What are negative interest rates and how do they work? Here's what to know about a negative interest rate, how they impact bonds, and more with Fifth Third.
Negative interest rates sound like a financial oxymoron. The whole point of interest, after all, is to compensate lenders for the privilege of borrowing money—not the other way around.
And yet, negative interest rates have been the reality in many European nations and Japan, and it is possible that the economic fallout of the Covid-19 pandemic will prompt the Federal Reserve to bring interest rates below zero for the first time in U.S. history.
While it’s hard to fathom a world where borrowers, in theory, get paid to use someone else’s money, the impact may not be as dramatic as it would seem. In fact, bond investors can still make money in an upside-down rate world, so long as rates continue to decline.
What’s the Point of Being Negative?
There are two primary ways that interest rates dip into negative territory. The first is with central bank policy. In response to the global financial crisis, European central banks rolled out negative rates to stimulate business and consumer lending with the goal of catalyzing economic growth.
The logic of bringing rates below zero is the same as with any rate cut—it incentivizes banks, companies, individuals and others to invest their money rather than keep it in the bank. Governments and corporations issuing debt, meanwhile, benefit from almost negligible borrowing costs.
Over the last decade, many countries—Denmark, Germany, Sweden and Switzerland, among others—have instituted negative rates. At its peak in 2019, there was approximately $17 trillion in negative-yielding sovereign debt, or, roughly 25% of all investment-grade debt.
Market forces can also drive bond yields below zero—as happened briefly with one and three-month T-bills in March. Remember that bond prices and yields move in the opposite direction. When investors drive up demand for a bond, it pushes up the prices and pushes down the yield.
How Negative Rates Impact Bonds
Low rates, in general, have made it harder for buy-and-hold investors to earn very much on their bonds, and negative rates certainly don’t help. Investors who buy negative-yielding bonds and hold them to maturity end up paying more for the bond than they earn back over time.
Large institutional buyers will, nevertheless, still buy these bonds because they need a safe place to “store” their money. Moreover, inflation also plays a role in the relative returns of these bonds. If inflation declines, as can happen in a recession, the real return on negative-yielding bonds don’t look so bad.
Yet, most bond investors don’t own bonds to maturity. Rather, they own them through mutual funds and exchange-traded funds that are constantly trading these securities. In that case, it is possible to make money on negative-yielding bonds—as long as interest rates fall further and in turn, drive up prices.
German government bonds have negative yields, and the Bloomberg Barclays Germany Treasury Bond Index has returned 4.8% for the year through April 30.
What It Means for Borrowing and Banking
Interest rates around the world may be in the red, but individual borrowers should expect to be paid for the privilege of borrowing money. Lenders still need to cover their costs and account for the credit risk that comes with issuing debt. While rates on some categories of lending could come down, there is a floor on how low lenders will go. This is particularly so for mortgages, which are expected to remain near their current levels, which was recently about 3.5% for 30-year fixed-rate loans.
Although negative interest rates are equated to a storage fee on bank deposits, individuals shouldn’t expect to pay money on their deposits. Among European countries where negative rates have been the norm, banks have avoided this strange reality by charging fees for select services or focusing on other areas, such as lending and asset management.
The views expressed by the authors are not necessarily those of Fifth Third Bank, National Association and are solely the opinions of the authors. This article is for informational purposes only. It does not constitute the rendering of legal, accounting, or other professional services by Fifth Third Bank, National Association or any of their subsidiaries or affiliates, and are provided without any warranty whatsoever. Deposit and credit products provided by Fifth Third Bank, National Association. Member FDIC.