Recently there has been an increase in news stories about the increasing amount of negative interest rate debt. I had hoped that the problem of negative interest rates would somehow go away as people realized they don’t provide a solution. Instead, the negative loans and bonds are increasing.
To understand negative rates imagine yourself with all your assets in the form of gold coins while living in a medieval city-state in Italy in the year 1500. To secure you gold you would have to deposit the funds with a goldsmith who had a safe. They would charge you a fee since they are merely providing a storage service. If the town was undergoing a siege by powerful adversaries then it would be necessary to charge depositors a government fee to pay for the extra troops needed to secure the city. Or an alternative would be for the government to make a payment to the adversaries to get them to stop attacking; either way it costs money to obtain security.
Another way to understand negative rates: suppose in modern times you lend your own funds directly to a homebuyer who gives you a Deed of Trust or a Mortgage document. Suppose the new owner-borrower is rather weak and undergoes hardship. They ask for deferred payments and threaten you by saying if you don’t cooperate that you will lose money if you foreclose on the home. By deferring the payments you are basically making the loan bigger; if you instead waived the interest then you made it a zero rate loan. What if you first made it a zero rate loan when they demanded help and then lent them additional funds when they announced they also had trouble paying property tax and might lose the house to the tax collector, threatening your Deed of Trust document. Suppose you as lender tell the borrower they now have a negative interest rate and that they can use the cash flow to pay their property tax bill. Basically, you as lender have been drawn into the problems of a weak borrower and have allowed them to ultimately pay back the loan at a discount. This is actually rather common in EM countries where borrowers suddenly “discover” they can’t pay and ask the lender for permission to have a short pay off (forgiveness of debt). The borrower threatens that the lender will be worse off if the home goes into foreclosure, so the lender decides to cooperate.
By contrast, the global financial system has collectively made too much debt and borrowers simply can’t pay, so as of now the “Invisible Hand” of the credit markets realizes a mistake was made in the past and existing debts if poorly underwritten must be modified to prevent a wave of debt defaults.
Currently in the U.S. there are two main types of debtors with excessive debt: one are corporate BBB rated borrowers who had their bonds rated by rating agencies that engaged in manipulative behavior to boost ratings to be higher than are correct. The other type of borrower is the Federal government, however they use the lowest possible interest rates and they can have the central bank print up money and buy the debt, thus preventing default (although they can indirectly default by causing inflation).
The global debt balances are simply too high; those that are Below Investment Grade credit quality (junk) will need a “haircut” or short payoff to survive and their lender/investors will lose money. Global debt is $500 Trillion (of which half are derivatives) and are about 5 times global GDP. Assuming only people in Developed countries can pay then each person owes $500,000 debt in Developed countries or $2million per family since kids don’t pay. However, much of this debt are corporate debts or bank derivatives that may simply evaporate in bankruptcy court.
In investing in bonds, loans, etc. there is a choice between junk lending with a very high probability of a material loss from defaulting borrowers who will pay off with a short payoff, or a true investment grade bond or loan yielding very low rates in the U.S. or negative yields in the EU or Japan. Better to lose 1% a year with a safe borrower (in negative yields) than to lose 30% to 80% or even 95% with debt default by a junk borrower. In Japan a commercial mortgage backed security was sold at a 95% discount (losses as bad as the 2000 tech stock crash), some property there dropped 90% in value.
Every time the yield for negative yielding bonds gets even more negative it is metaphorically the same as a medieval city-state having to charge taxpayers more to raise an even bigger army to defend the city against barbarian attackers seeking to break into the vaults. The worse things get the more it costs to protect one’s assets.
The fundamental problem is a combination of too much debt (which makes more spending and investing unlikely) and loss of employment in high cost Developed countries as jobs flee to low wage EM countries.
Investors need independent financial advice about the growing problem of negative interest rates.