A tour of eurozone government bond exchange-traded funds (ETFs) provides a glimpse of the negative interest rate challenge that may confront Canadian investors within the next few years.

As of March 9, iShares Euro Government Bond Zero- to One- Year UCITS ETF, managed by BlackRock Advisors (U.K.) Ltd., sported a negative yield to maturity (YTM) of minus 0.25%, while the one- to three-year and the three- to five-year versions had YTMs of minus 0.8% and minus 0.5%, respectively.

Investors in short-term eurozone government bonds are paying for the privilege of lending money to those governments. In nominal terms, at least, negative interest rate policy (NIRP) has turned short-term eurozone government bonds into guaranteed money-losers for their investors.

In Japan, where recurring deflationary episodes have been a reality for more than two decades, bond yields are even lower. The YTM of 10-year Government of Japan (GoJ) bonds recently dropped to an all-time low of minus 0.1% and almost 75% of GoJ bonds offer yields at or below zero. With short- and medium-term bonds anchored below zero, long-term bond yields also plummet. The 30-year GoJ bond’s YTM recently hit a record low of 0.46%.

NIRP is designed to overcome what traditionally has been viewed as the zero interest rate boundary of conventional monetary policy. When inflation chronically falls below target levels of 2% – particularly when there is a sizable output gap in an economy – zero interest rates may be inadequate to offset the onset of persistent deflation. NIRP is designed to stimulate an economy by encouraging consumption by discouraging saving, promoting low-cost lending by banks and pushing a nation’s currency exchange rate lower.

NIRP is rapidly becoming a standard tool in central banks’ arsenals. The Bank of Canada recently announced that the effective lower boundary for its policy interest rate is in the area of minus 0.5% and that NIRP is an option if Canada’s economy suffers a major negative shock. In the U.S., the Federal Reserve Board added a scenario of negative yields on three-month treasuries to its stress test for banks for the first time.

Under the stress test’s severely adverse scenario, rates on three-month treasuries would plummet to minus 0.5% and remain there for a three-year period, while the yield on five-year and 10-year treasuries would hit lows of 0% and 0.2%, respectively.

Although NIRP should not be the baseline outlook for your clients’ investment plans, you need to consider potential implementation of NIRP. In February, the probability of negative interest rates in the U.S. by the end of 2017 climbed to 17% (as implied by eurodollar futures contracts). Subpar global economic growth, combined with major downside risks (e.g., China’s”hard landing”), also argues for contemplation of a NIRP scenario in portfolio design.

You should ensure that your typical balanced client portfolio includes investment-grade bonds with durations that approximate the overall Canadian bond market. That market, as measured by the FTSE TMX Canada universe bond index, has an average duration of approximately 7.5 years. In a world in which short-term rates go negative and the entire yield curve shifts downward, some longer-duration exposure will be critical. Simply holding cash to buffer portfolio volatility won’t be enough. IE

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own securities mentioned in this article.

© 2016 Investment Executive. All rights reserved.