Living in a World of Lilliputian Interest Rates

Q3 | October 2019

Topic: Investments

Geoffrey J. Gouinlock CFA

October 1, 2019

Image used with permission: iStock/erhui1979


Print & Share

Print

Living in a World of Lilliputian Interest Rates

Q3 | October 2019

One of the most important developments in global capital markets over the last many years has been the prevalence of abnormally low interest rates. Today’s low rates are historically unprecedented, and negative rates are truly “other-worldly.” To me, they seem more out of a novel like Gulliver’s Travels or Alice in Wonderland than from a macroeconomics textbook.

In this piece I’ll try and explain how low rates are squeezing investors, share some data about our Income Fund (NNAIF), and offer a reminder about the importance of asset allocation and planning. It would be comforting to think that a straight-forward solution exists to the pinch in the wallet that comes from low rates. Unfortunately, unlike Alice, this is no dream. Investors need to moderate return expectations and incorporate lower interest rates into their financial plans.

Through the Looking Glass…

Government bonds in many developed economies, across a wide range of maturities, yield less than zero. Historically, academics have discussed the concept of negative interest rates. But mostly it was to describe the theoretical limits of how low interest rates in the real world could fall. After the Great Financial Crisis, the concept of negative interest rates moved from its arcane place in the academic world into consideration as a tool to provide extra monetary easing – part of a range of Quantitative Easing (QE) tools that central banks felt necessary to stave off a possible slide into a 1930s-style depression.

Since being adopted by the European Central Bank and the Bank of Japan in 2014, and despite a recovery in the global economy, negative rates have become an increasing feature of government and even corporate debt markets. Over US$17 trillion of debt now trades at a negative yield, representing 30% of the global stock of marketable investment-grade debt. Unsurprisingly, negative yields have produced a legion of heretofore unconsidered issues. For instance, policy makers in Germany are discovering that rather than encourage people to borrow and spend, Germans are actually saving more to adapt to a world of low returns. Likewise, the European banking industry is being slowly strangled by declining lending margins. It’s now possible to get a negative yielding mortgage in Denmark. That’s right, the bank pays you to borrow!

Depending on one’s station in life, this era of low and even negative rates ranges from a blessing to a curse. For borrowers, it is a blessing. Businesses can more affordably acquire capital equipment and consumers can likewise more easily afford car and mortgage payments. However, it is a curse for clients who are accumulating capital (saving), or those who are living on the return from their savings.

Otherworldly Interest Rates make for Real World Problems

This burden has two related, but separate parts. The first is that bond returns will assuredly be lower in the future than they have been historically. For many investors an allocation to fixed income (bonds) is fundamental to reducing the volatility in their portfolio, especially when equity markets are unsettled or when they are in the stage of life when they are living off their accumulated capital. Quite simply, low current interest rates will reduce the future returns of any “balanced” portfolio. The second aspect of this problem is that, as a practical matter, everybody needs a certain amount of liquid cash. From an investment portfolio perspective, Nexus clients generally have a target allocation of 5% to “cash”. We invest those funds in money market instruments that currently return about 1.75%. But outside their investment portfolios clients need cash for transactional purposes as well. In today’s world of low rates, that cash is truly idle, often earning nothing at all.(1)

Low interest rates also penalize people who have cash from other circumstances. Consider the case of someone who has received an inheritance or sold a house or a business. Historically, they could have used bank GICs and rolled them for an indefinite period while deciding how to invest or how to spend their new capital. The returns were not extravagant, but at least the balance grew. Today, that’s a much tougher task. Rates are low, taxes are high, and together with fees, it is likely that the value of these sorts of balances loses ground to inflation.

Prompted by clients frustrated with large cash balances and the prospect of meagre returns, we recently looked at whether our Nexus North American Income Fund (NNAIF) might provide a feasible solution.

Since being established in 2002, through a combination of capital gains, dividends and interest, the NNAIF has produced excellent tax-efficient returns (+6.1% pre-fee compound annual growth rate), and has an excellent comparative record against its benchmark, the FTSE Canada Universe Bond Index. But we have been reluctant to broaden the usage of the NNAIF. It is designed and managed to provide better returns than the bond market, and it is explicitly not a money market instrument. If a client had cash set aside for an upcoming use, we generally counselled that unless they could give it to us for at least two or three years, it probably wouldn’t be best for us to manage it. However, examining the return data of the NNAIF more closely, the Fund may have somewhat broader utility than we have generally assumed. As long as a client doesn’t need their funds for at least 12 months, the risk of noticeable capital loss is actually quite low. In support of this assertion, we note that there were only six instances of the 190 12-month periods since the Fund was established, that the Fund declined in value from where it had been 12 months before, and never was that loss greater than 1.5%.(2) In the other 184 12-month periods returns were variable, but averaged more than 5%. So, for funds that are not going to be spent for more than a year, the NNAIF might be a more valid alternative for client funds than we have previously counselled.(3)

Unfortunately, for amounts of money that need to be liquid and available at short notice, the NNAIF remains unsuitable. The components of the Fund that generate superior long-term returns also produce more volatility over short periods than what is suitable for a “cash” substitute.

No Happy Ending

Low and negative interest rates are a huge penalty for savers and those with lower risk tolerances. They make it more difficult for people to have a comfortable retirement. In such a low return world, there is a temptation to over-allocate away from cash to other asset classes as a means of generating better future returns. This needs to be avoided, because liquidity, especially in times of crisis, is exceedingly valuable. Likewise, sitting on cash that really should be invested for the long-term comes with a huge opportunity cost. The current environment, with its abundant geopolitical and economic worries has encouraged many investors to move some portion of their investments to the sidelines. This is understandable, but really is no different than market timing – an approach to investing that almost guarantees a sub-optimal experience.

In Gulliver’s Travels, Gulliver repairs his boat and leaves Lilliput for England. In Alice in Wonderland, Alice awakens from a dream and drinks tea! Alas, such a “happily ever after” solution does not exist for the strange circumstances that investors are living with today. Instead, having a plan, and sticking to it, is the best way to achieve realistic financial goals for you and your family. Plans should be customized to your individual circumstances and directly address how much cash / liquidity you need in your life. How this world of low or negative rates eventually plays out remains unknown. But a disciplined investment process, along with a customized financial plan, can help you make the best of it.

(1)  Does anyone else besides me get a kick out of the labelling Canadian banks use for their “savings” accounts? For annual rates between 0.9% and 1.05%, they label their savings accounts with names that stretch the meaning of Premium, Bonus, Advantage and High Interest.

(2)  There were four 12-month periods where the fund had returns between 0 and 1.0% and two where the fund’s returns were between 1.0% and 1.5%.

(3)  Fees and taxes will also factor into the suitability of the NNAIF and whether or not it provides better value than what’s offered by the banks. Please contact us to discuss your specific situation.

More Like This...

See another CRM2 blog post that may be of interest to you.

No posts found.

More Like This...

See another Foundations & Endowments blog post that may be of interest to you.

That Giving Feeling

Topic:
Foundations & Endowments, Tax Planning
Excerpt:
Summer is now a distant memory. In fact, a radio announcer declared only 77 days until Christmas. Ugh. It is usually in the last quarter of the year

More Like This...

See another Human Interest blog post that may be of interest to you.

What a World!

Topic:
Human Interest
Excerpt:
You don’t need to read a blog from your most trusted investment advisor to realize that 2020 might go down as one of the most notable and difficult

More Like This...

See another Inside Nexus blog post that may be of interest to you.

Swimming Naked

Topic:
Inside Nexus
Excerpt:
Warren Buffett has a wonderful line. “Only when the tide goes out do you discover who's been swimming naked.”

More Like This...

See another Investments blog post that may be of interest to you.

It’s a Topsy-Turvy Year: Investing During COVID

Topic:
Investments
Excerpt:
This year has been plenty weird. For starters, it feels like January was about five years ago… if you can remember it at all. Putting aside the health

More Like This...

See another Pearls of Wisdom blog post that may be of interest to you.

“Work, Work, Work, Work, Work, Work”

Topic:
Pearls of Wisdom
Excerpt:
This has been a busy year. I’ve had lots happening on the home front (a wedding!) and lots going on at the office (too long to list!) Managing work

More Like This...

See another Tax Planning blog post that may be of interest to you.

The (U.S.) Taxman Cometh

Topic:
Tax Planning
Excerpt:
Like the medical patient who expects to endure a fair bit of poking, probing and prodding from the doctor, clients of financial providers have had to

More Like This...

See another Wealth Planning blog post that may be of interest to you.

Estate Planning: Questions from our Virtual Chat

Topic:
Wealth Planning
Excerpt:
Helping clients with their estate planning is something we do here at Nexus. However, we are often involved in identifying the best tools for the

On a Side Note…

See another CRM2 Nexus Notes Quarterly article that may be of interest to you.

No posts found.

On a Side Note…

See another Foundations & Endowments Nexus Notes Quarterly article that may be of interest to you.

No posts found.

On a Side Note…

See another Human Interest Nexus Notes Quarterly article that may be of interest to you.

It’s About Time

Topic:
Human Interest
Excerpt:
Over the last 25 years, we have written frequently about time. In fact, in 2010, our annual client presentation carried the same title as this article

On a Side Note…

See another Inside Nexus Nexus Notes Quarterly article that may be of interest to you.

A Virtual Nexus Welcome

Topic:
Inside Nexus
Excerpt:
We are excited to welcome Preethi Khatri Chetri to Nexus.

On a Side Note…

See another Investments Nexus Notes Quarterly article that may be of interest to you.

Uncertainty… Who Needs It? Apparently, We Do.

Topic:
Investments
Excerpt:
It is not exactly a revelation to say that uncertainty contributes to stress. In “normal” times – take 2019, for example – three common sources of

On a Side Note…

See another Pearls of Wisdom Nexus Notes Quarterly article that may be of interest to you.

China’s Larger Role in the World; Immortality in a Test Tube

Topic:
Pearls of Wisdom
Excerpt:
Reading is one of the principal occupations in our profession. As we digest a wide range of material, interesting ideas and surprising facts – some

On a Side Note…

See another Tax Planning Nexus Notes Quarterly article that may be of interest to you.

The (U.S.) Taxman Cometh

Topic:
Tax Planning
Excerpt:
Like the medical patient who expects to endure a fair bit of poking, probing and prodding from the doctor, clients of financial providers have had to

On a Side Note…

See another Wealth Planning Nexus Notes Quarterly article that may be of interest to you.

From the Editor: Happy New *Planning* Year

Topic:
Wealth Planning
Excerpt:
As the weather cools and the leaves begin to change colour, it seems to me that fall is the more natural start of a new year compared to the start of