Falling interest rates concept

Will negative interest rates come to Canada? European loan and many life insurance contracts already are running with negative rates.

Competitive rate-cutting via the overnight rates – and even longer rates with minus signs – would mean investors are willing to pay governments and financial services institutions to store their money. Indeed, investors are shopping for good terms, even in the present deposit market, in which many sovereign bonds are paying negative rates: that is, these bonds return less money than was paid at time of issue.

This seems unworkable, but lenders can make negative interest rates work by lending at -1%, then borrowing from depositors at -3% – and the lender clears 2%.

Germany, France, the Netherlands, Switzerland and Japan now require investors to pay to store their money. In this weird financial market, banks find making money difficult when the yield curve is flat to negative. Insurance companies find selling annuity contracts is challenging because they offer a stream of payments that may be less than the cost of buying the annuity even before inflation is figured into the deal.

Negative rates even apply to less than stellar sovereign debt; for example, Greece. Yet, Greece’s debt is classed as relatively high-yield sovereign junk. In early October, Greece’s national debt-management agency reported it had raised 487.5 million euros by selling 13-week treasury bills yielding -0.02%, which means investors pay Greece to hold their money! This seems preposterous because in 2012 Greece’s sovereign bonds paid almost 42% – compared with low single-digit yields on Germany’s and the U.K.’s sovereign debt.

Greece’s debt is actually a good deal for investors compared with more senior debt. For long-term parking of money, as of Oct. 23, the Swiss National Bank offers 10-year sovereign bonds that pay -0.75%. Germany’s 10-year bunds pay -0.40% for 10 years, and Japan’s 10-year sovereigns pay -0.15%.

There is too much money sloshing around the world. As populations age, people save more money for their old age and try to find places to put it. As the elderly tend to be risk-averse, they offer their money to banks with government- insured accounts or buy government bonds. Thus, there is an avalanche of cash in search of a cozy mattress. That’s why senior-grade governments that are virtually certain to return money can charge relatively small sums for storage. And less esteemed governments can pay little to borrow. In the market of lesser credits, Greece’s current 10-year rate is +1.30%. That’s a junk-bond premium in a market of negative rates on more esteemed sovereign debt.

Driven by central banks’ quantitative-easing programs, which bought bonds to give banks cash during the financial meltdown that began in 2008 – and, more recently, investors’ apprehensions that the world’s economies and stock markets are due for a big drop – worldwide debt attributed to negative-yield government bonds reached US$16.4 trillion in August, as reported by the Associated Press. That’s up from US$12.2 trillion in mid-July and US$5.7 billion in October 2018. Banks are finding that making money via conventional lending is difficult.

By 2015, 40% of Europe’s sovereign bonds offered negative yields, as the Economist points out. Then, once Europe’s economies strengthened, the minus signs on sovereign bonds disappeared and rate normalcy – that is, paying to borrow money – returned. However, economic weakness has resulted in a return to negative rates. As of August 15, 100% of Switzerland’s sovereign bonds had negative rates, matched rate-for-rate by sovereigns issued by the Netherlands and Germany.

Banks can make negative rate lending work by ensuring they can borrow for less than they lend. But insurance annuities are more difficult to sell right now.

Frédéric Godin, assistant professor of financial mathematics and actuarial science at Concordia University in Montreal, explains the bizarre world of annuity and other time-based contracts written with negative returns: “You would put more value on cash [to be redeemed at a time] further away than near term,” Godin says. “With positive interest rates, a sum is worth more today than it is in 10 years. But with negative interest rates and guaranteed losses, the present discounted value of a distant future loss is less than the loss tomorrow.”

Germany-based insurance giant Allianz SE explained in an April 2016 report that under conditions of dropping interest rates, yields will drop faster than guarantees. Insurers would have to lower their guaranteed rates on new business; to generate more money, insurers would have to reset their asset allocations to offer more risk and less liquidity.

In fixed-income, that would mean more subinvestment-grade debt and increased cost of hedging currencies or risks.

As you may expect, insurance companies and banks accepting lower-quality assets to generate income find their book value declining as investors disdain those lower-quality assets. Lenders’ and insurers’ share prices would decline in that scenario. In August, banks’ shares collectively were down by 24% in Europe and by 23% in Japan year-to-date.

With negative interest rates, financial services institutions prefer to show book value at origination of loans or annuity contracts, says Don Forbes, head of Forbes Wealth Management Ltd. in Carberry, Man. Forbes, a licensed insurance agent and financial planner, points out that financing future-paying insurance agreements such as whole-life policies or annuities will require more negative-paying bonds than conventional positive-paying bonds. That would raise costs and lower profits. Already, many of Japan’s life insurance companies are technically insolvent, he says.

If business conditions worsen in the U.S. or Canada, negative rates could become a reality. However, a financial system stuffed with negative-paying debt would be at the mercy of improving business conditions and a return to positive interest rates. An improving economy would reduce the value of negative-paying debt, annuities and other contracts priced to pay less in the future than today.