By Don Gould

Negative interest rates–yes, interest rates below zero–are receiving a lot of attention these days. Central banks in Japan, Germany, Sweden, Switzerland and Denmark all are experimenting with negative short-term interest rates. Yields on longer term bonds have also fallen below zero in many of these countries; it’s estimated that between $3 and $7 trillion worth of bonds worldwide now carry a negative yield. Even the US Federal Reserve, which only recently raised short-term rates, has indicated it will consider a negative interest rate policy (NIRP).

Until recently, the concept of an interest rate below zero was mostly confined to the realm of theory. But as economies around the world struggle, central banks have taken extreme measures in an attempt to stimulate economic growth and avoid price deflation. Negative interest rates are one of their tools.

The theory is that negative interest rates encourage more business borrowing and spending on plant and equipment, as well as encouraging investors to seek out riskier investments with higher expected returns. In turn, that pushes up asset prices and perhaps stimulates consumption. A negative interest rate could also depress the currency in foreign exchange markets, making that country’s exports more competitively priced. The jury is decidedly out on whether any of this actually works. Some suggest that negative interest rates do more harm than good, sapping consumer and investor confidence by sending a message that the economy is in dire straits.

At first glance, it’s not clear why anyone would buy or hold a bond that actually requires the investor to pay interest to the bond issuer. And yet that’s exactly what’s happening on trillions worth of bonds today. On further inspection, it turns out there are sound reasons for one to accept a negative yield under certain circumstances.

One case is that of institutional investors who are required by their investment policy to maintain holdings in the shortest term, safest instruments available, for example, Treasury bills. If the interest rate on such investments happens to be less than zero, these investors really have no choice but to accept the negative rate. While in theory one could obtain paper currency and store it in a vault, this is impossible for the world’s multi-trillion dollar money markets as a whole, particularly given the need for electronic safekeeping and instantaneous liquidity.

A second situation where it would make sense to accept a negative yield is in an environment of deflation, that is, falling prices. For example, if prices are dropping at a rate of 3% per year, an interest rate of -1% would actually represent a positive inflation-adjusted rate. To see how this would work, suppose you have $10,000 dollars today and you invest it at -1%. One year from now you will have $9,900. However, you would only need $9,700 a year from now to buy what $10,000 buys today (since prices will have dropped 3%). Thus, in our example, $9,900 a year hence represents an increase in purchasing power versus $10,000 today.

Alas, for years bond investors have been accepting rates that in many cases don’t even match inflation, and this represents one of the great investment challenges of our time.