by Mike Jaczko and Max Beairsto
Europeans are doing it. Japanese are doing it.
Embracing negative interest rates, that is.
But should pharmacists do it?
What are negative interest rates?
“Negative interest rates refer to a scenario in which cash deposits incur a charge for storage at a bank, rather than receiving interest income. Instead of receiving money on deposits in the form of interest, depositors must pay regularly to keep their money with the bank. This environment is intended to incentivize banks to lend money more freely.”
The concept of “negative interest rates” is creeping slowly into our financial lexicon. But what exactly are negative interest rates, and what impact does their existence have on the average Canadian? Will negative interest rates come to this country? And what impact will they have on Canadian pharmacists’ lifestyle and retirement planning? The following example will demonstrate how negative interest rates differ from more traditional financial vehicles.
Traditional bonds versus negative interest rate bonds
Here is how traditional bonds work. Fixed income instruments pay an interest rate. This interest rate can be paid to the bondholder in a couple of traditional ways: a bond that pays a coupon or a bond bought at a discount, which matures at par, called zero-coupon bonds.
Coupon bonds are generally bought at, or somewhere close to par. During the time the bondholder owns the bond, the bond issuer pays a coupon, typically every six months. The coupon rate on the most creditworthy (AAA-rated) bonds has fluctuated over time, but has typically never paid lower than 2-3%. For example, if you purchase a $100, one-year bond that pays 3% at par, you would receive a $1.50 coupon payment at the six-month mark and a $101.50 payment at maturity ($100 of principal, plus the final $1.50 coupon payment). Most long-term government debt, as well as nearly all corporate debt, is sold in the form of traditional, coupon-bearing instruments.
Zero-coupon bonds are purchased at a discount to par, and then mature at par. The difference between the two prices serves as the interest rate.
- Example: if you were to purchase a $100, one-year, zero-coupon bond for $97.09. This difference ($97.09 to $100) reflects a 3% interest rate over the course of one year. Most short-term government debt is sold as zero-coupon bonds.
Negative interest rate bonds
Currently, a considerable portion of sovereign European and Japanese debt is issued yielding negative interest. There is approximately $17 trillion (USD-equivalent) of debt with a negative interest rate, most taking the form of zero-coupon bonds, which are logistically simpler to handle than having bond purchasers send the government or corporation a cheque every six months.
- Example: if you were to purchase a $100, one-year bond but this time, instead of paying LESS than $100 at the time of purchase, you pay MORE than $100 (a premium) for the right to receive $100 in 12 months’ time. Let’s say the interest rate is negative 1%. In order to receive $100 at maturity, you have to lend the government of Japan or the European country issuing the bond $101.
Why this strategy?
- To spur growth
Interest rates were never meant to be negative, but there have been monetary policy decisions made by central bankers in some countries in an attempt to incentivize investors to place their savings into riskier asset classes in the hopes of spurring growth. This strategy is also used as a policy tool to help stave off deflation in an economy.
- To lead to depreciation
There is also the hope that by holding interest rates at very low levels, the country’s currency will then depreciate against other currencies around the world that maintain higher relative interest rates (people want to hold currencies that pay them more). If a country’s currency has depreciated, the exports of that country become more attractive to other countries; this should, in turn, help stimulate economic activity in the exporting country.
- To match assets with liabilities
Many pension funds and mutual funds are constitutionally bound to buy government securities. Government bonds are traditionally viewed as the safest asset class (risk free). Given that many pension funds feature “defined benefits” (they know how much money they’re going to have to pay out in the future), they are required to match their assets with their liabilities. Therefore, they purchase these government bonds, where the chances of default are minuscule (developed-world countries very rarely default on their debt).
In Part 2 we look at the implications of negative interest rates.
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.
Mike Jaczko and Max Beairsto recently presented at Pharmacy U Toronto.