Searching for yield

Negative interest rates are a byproduct of the Global Financial Crisis.

How did we get here?

I'm sure that some of you weren't aware that interest rates could be negative. I don't blame you; the idea that someone will pay you to borrow money doesn't make a lot of intuitive sense. So what's the deal with sub-zero interest rates? Well, negative interest rate policies (NIRP) first surfaced as a response to the Global Financial Crisis. Plunging economic growth and panicky markets forced many central banks into negative territory to try to kickstart the global economy. The hope was that negative interest rates would incentivize more borrowing and translate into more economic growth. For better or for worse, the European Union, Switzerland, Sweden, Denmark, and Japan have all adopted NIRP. North America has remained free from NIRP thanks to the US Federal Reserve, who, during the financial crisis, opted to purchase debt from companies rather than lower rates below zero.

How do negative interest rates work?

For the most part, these policies behave as one would expect. A financial institution (FI) pays interest on any money left in their account above what is required by regulation. We often refer to this money as "excess reserves." In the past, these FIs would have received payment on excess reserves rather than pay a fee. The hope was that, rather than paying a fee, FIs would prefer to lend to businesses and consumers at some positive interest rate. Although, in theory, this is true, in practice, NIRPs have had the adverse effect of giving borrowers more bargaining power. That came as a result of an asymmetric market where there were more lenders than borrowers. As would happen in any free market, the increased bargaining power created a borrowing bonanza at the expense of lenders and savers. Borrowers were able to "shop around" and find someone to offer them the lowest interest rate. As a result, that theorized positive interest rate FIs would receive in practice became lower if not negative.

Negative interest rates help foster search for yield.

What are risk premiums?

Before getting into the problems with negative interest rates, we need to discuss risk premiums. For starters, interest rates are more complicated than you would think. There's lots of information contained within them, and it is common practice for economists to decompose interest rates into different "layers." In doing so, economists get a better idea of what is happening under the hood of the economy. The base of any interest rate is generally some form of a risk-free asset, typically the yield on a government bond. We can consider a government bond to be risk-free because the government can always print more money to repay its debt (assuming the bond is in the country's currency). Any interest rate that is higher than the risk-free rate carries a "risk premium." That means that the investment is not risk-free, and, as a result, the investor wants to be compensated for taking on more risk. Risk can take many forms, but, in general, investors want compensation for default risk, longer-term loans, and liquidity. One of the big problems with negative interest rates is that it compresses these risk premiums through a dynamic called searching for yield.

What does it mean to "search for yield"?

Low-interest rate policies hurt investors who are risk-averse by reducing their potential rate of return from risk-free assets. The introduction of NIRP amplifies this dynamic by essentially taxing investors who put their money into riskless investments. As a result, NIRP forces investors to look to riskier markets to meet their required rate of return. As more investors look for risk premiums, those risk premiums begin to compress as investors crowd each other out. That results in even more risk-taking, where investors are scrambling for yield. Hence the phrase "search for yield."

Not all risk is the same.

Remember that the type of risk investors can choose takes the shape of 3 broad categories: interest rate risk, credit risk, or liquidity risk. Credit risk exposes you to lower quality investments while interest rate risk, aka duration risk, refers to the length of the investment. Longer investments pose more uncertainty and generally require a premium over shorter investments. That's one reason why the yield curve is usually upward sloping. Meanwhile, liquidity risk refers to investments that are not easy to sell. These are typically private assets or products that are not available on an exchange and requite a broker to find a buyer for you. Recently, many pension funds have been taking advantage of these liquidity risk premiums.

Pension funds are in a pinch.

Pension funds have no choice but to search for yield.

Lower/negative interest rates are pushing pension funds into riskier assets to meet their pension obligations. Making matters worse, the size of the retiring population is greater than that of the working population. That means that over time, the payments to retirees will be larger than the income coming from the working population. To meet all of the pension obligations, pension funds must use their current asset base's growth to fund future pensions. If you're not convinced, take a look at the Canadian Pension Plan (CPP) portfolio. Today it contains about 10 percent government bonds relative to 28 percent ten years ago. The chart below shows CPP's asset mix in 2019. Notice how the majority of the portfolio holds equities, with nearly half of those equities being private companies.

Source: CPP annual report 2019

Why should I care?

Although your pension is undoubtedly invested in riskier investments than in the past, pension funds are highly diversified and manage their risk appropriately. The threat of people losing their pensions isn't what is keeping policymakers up a night. The more significant issues come from an aging population that threatens to keep inflation persistently low. Without inflation, central banks are unable to raise interest rates and create a buffer for when the next crisis hits. More troubling is that searching for yield has resulted in plenty of capital misallocation. Companies that are essentially insolvent have the opportunity to continue to refinance at lower interest rates. Below is a diagram from the Heisenberg Report, which shows the nasty feed loop that comes from persistently low-interest rates.

Source: Heisenberg Report

I always say that context is important, and in this case, it's no different. When you consider that an increasing share of the world's debt is trading with a negative yield, it shouldn't come as a surprise that riskier bonds and equities have performed so well. Yes, these markets are at all-time highs, but the dynamics behind who buys them have changed. Pension funds and other institutional investors weren't being forced into these assets in the past. In the coming weeks, I'll dive into more of these dynamics that come from lower interest rates.

Tiago Figueiredo