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Negative interest rates: Are they headed our way?

We are in a ‘lower for longer’ interest rate cycle that doesn’t seem to show any signs of abating soon

negative interest rate

The concept of negative interest rates is still difficult for most investors to comprehend. Imagine walking into your bank and depositing $1 million, only to find that in a week or two your account balance is down to $999,000 or $998,000.

This is essentially what is happening now across many European countries—for example, France, Germany and Switzerland—and Japan. In fact, Deutsche Bank estimates that there are more than $15 trillion worth of negative-yielding bonds globally, representing more than one-quarter (27 percent) of all bonds outstanding.

Could this happen in the U.S.?

According to a recent assessment by Charles Schwab, it seems highly unlikely. “The Federal Reserve has said that it’s not a policy that they would like to pursue…and secondly, they’re not even sure that it’s legal under their charter,” according to Schwab’s Bond Insights newsletter. Nevertheless, there is a pressing interest-rate problem that U.S. investors should be concerned about.

Low or negative interest rates overseas, coupled with a slowing domestic economy and continued global weakness, have forced our 30-year Treasury yield below 2 percent for the first time in history, and the yield curve has become inverted. With a “normal” yield curve, investors receive more income for tying up their money for a longer amount of time, but a yield curve inversion means that short-term interest rates are higher than long-term rates.

This rare occurrence has investors spooked and economists perplexed. The Fed Funds Rate is at 2 percent to 2.25 percent (money markets) while the yield on a 2-year Treasury bond is near 1.60 percent and the 10-year Treasury is even lower at 1.55 percent (as of early September 2019).

Why is this a problem? An inverted yield curve may suggest good economic growth today but lower growth in the coming years, and therefore is often seen as a forewarning of a recession.

So, what should income-focused investors do?

We are in a “lower for longer” interest rate cycle that doesn’t seem to show any signs of abating soon. Accordingly, we have been advising clients to rethink their income portfolios and make adjustments, as the old rules may not apply anymore.

Rather than overreaching for income—“chasing yield”—through the purchase of high-yield bonds or other instruments that can dramatically increase the credit risk or illiquidity in their portfolio, savvy investors should explore replacing ordinary income bonds with some combination of the following:

  • Municipal bonds with longer durations and potential double tax-free income
  • Preferred stock—a hybrid of a stock and bond that typically pays higher dividends than common stock (often tax advantaged)
  • Dividend equities—dividend growth stocks that also allow for a covered-call overlay strategy to help reduce risk and magnify income
  • Structured notes—securities issued by financial institutions that have both a bond component for principal protection and an equity derivative component that provides some upside potential
  • Cash-secured puts, which essentially pay you to wait for the opportunity to acquire equities below today’s market price

These higher-yield instruments not only have the potential to be more efficient generators of portfolio income but also can offer significant tax advantages. In pursuing any of these strategies, however, it’s vital that you work closely with your financial advisor to ensure you’re investing properly and maintaining diversification to meet your ongoing needs.

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