by Mike Jaczko and Max Beairsto
What are the implications of negative interest rates?
Do you as a pharmacist rely on a pension fund? If so, you’re like most people, who depend on a pension to some extent to help fund their retirement. Unfortunately, if negative interest rates are the new normal, many pension funds will have difficulty meeting their commitments. As mentioned, government bonds are a key component of pension funds’ returns. Negative interest rate bonds force the bondholder to pay more for the bond than they will ultimately get in return; purchasers know in advance they are going to take a loss. If this is the “new normal,” then this will severely deplete pension funds.
As well there is no consideration for the impact of inflation. Most developed countries around the world are experiencing inflation somewhere in the range of 1-2%, which causes further deterioration in the purchasing power of fixed income assets. If a pension fund is holding an instrument that is decreasing in value NOMINALLY at 1% per year, in addition to decreasing another 1-2% due to inflation, the REAL interest rate on these bonds is actually negative 2-3% per year. Add in the fact that pension funds incur expenses (trading costs, management fees, staffing costs, etc.), it should be very clear that pension funds will not survive long term in a negative interest rate environment.
Negative interest rates also tend to create distortions in other asset classes. The interest rate of a country’s sovereign bonds has typically served as the baseline by which all other interest rates are set and many other assets valued. One common method for valuing equities involves measuring the relative value of the earnings yield of a stock against the risk-free rate. If the risk-free rate (often defined as the yield on a sovereign bond of the country in question) is negative, it implies that one should be willing to pay an infinite price for any equity that is capable of continuing to grow. This partially explains the historic run that growth stocks have had in the last decade.
You must also consider the serious impact on mortgage rates and the housing market. Most mortgage rates are set by taking the risk-free rate and applying a spread to reflect the relative risk. Home values are also a function of interest rates; the higher the mortgage rate, the less likely it is that someone is prepared to take on a mortgage to buy a house, the less demand there is for house ownership, and the price of housing falls.
We have already seen our first NEGATIVE MORTGAGE RATE in Europe. Most finance professionals find the notion difficult to comprehend. No matter how creditworthy the borrower, the risk of default on a mortgage is never zero, and the implication of a negative mortgage rate is that the borrower is worthy of being paid to borrow money to buy a house. This distortion of the mortgage industry has been the reason we have seen a significant run-up in the price of real estate in nearly every major developed market around the globe.
Are negative interest rates coming to Canada?
Will negative interest rates come to Canada? In 2008, we saw both Canada and the U.S. central banks cut their target rate to 0-0.25%. This caused bond yields to fall; the yield on the U.S. two-year bond fell to a low of 0.14%. Most experts view the steep cut in interest rates as one of the actions that helped the financial system avoid collapse in 2008. As a result, most experts believe that at specific times, there is merit in reducing interest rates to 0%. Thoughts on the impacts of taking rates lower than 0% are much more mixed. The results of the negative interest rate experiment in Europe and Japan are frequently debated at the highest levels of governments around the world. In fact, U.S. President Donald Trump has recently come out in favour of zero or negative interest rates.
Currently, it seems unlikely the Canadian central bank will venture into negative interest rate territory. But the future is impossible to predict with 100% accuracy. Policymakers change, and given that we are seeing political pressure in the U.S. to move to a much lower interest rate environment, we can never fully rule out a move to this strategy.
How can you protect your portfolio?
To protect your investment portfolio from the impact of negative interest rates, we strongly recommend that non-correlated asset classes constitute a portion of your investment portfolio. These asset classes strive to achieve a positive return in all kinds of economic environments. We at KJ Harrison have been working diligently since 2009 to evolve our non-correlated asset class offerings so we can continue to be the most relevant private client firm in Canada for our pharmacist clients.
Mike Jaczko, BSc. Phm, RPh, CIM®, a pharmacist by background, is a portfolio manager, partner and member of KJ Harrison Investors, a Toronto-based private investment management firm servicing individuals and families across Canada. For more information on this topic, email firstname.lastname@example.org.
Max Beairsto, B.Sc. Pharm., MBA, CVA is a pharmacist and valuation analyst with Enterprise Valuators, an Edmonton-based business valuation firm that focuses on business valuations and sale advisory of small and mid-sized private companies.