Investing in a negative rate world

As Canada’s economy continues to suffer — many economists are now expecting fourth quarter growth to be flat — the chatter around negative rates is getting louder.

While forcing banks to spend may or may not help spur the economy – and in negative rate regions like Denmark, Sweden and the Eurozone, it doesn’t appear to be doing much – it will certainly have an impact on savers. Why? Because bond and bank account rates will get so low that anyone storing money in one of these vehicles will make next to nothing.

Laurence Booth, the CIT chair in structured finance at the Rotman School of Management, is concerned about what negative rates may do to retirees – and what low rates are doing to them now. “[Low rates] are killing retirement portfolios,” he says.

The main question that people have about negative rates is whether or not a saver will have to pay the bank to store money in a bank account. Some banks in Denmark, which have been in a negative rate environment since 2012, are now charging clients. In March of last year, Denmark’s FIH Erhvervsbank began charging some customers 0.5% on their assets. It’s not hard to see how this could wreak havoc on retirees, many of whom need all the money they have saved.

One of the goals behind negative rates is to get people investing more in the capital markets – if you can’t make money in bonds or savings accounts, then there’s only one other place to go. However, even that’s become riskier. As rates have fallen, investors have piled into dividend-paying stocks, which have always been a favourite of retirees.

Many of these equities are now more expensive than their historical norm, which means that if they fall, they’ll fall harder than they would have otherwise. Broad markets are also more expensive, in part because of this push into equities. The S&P 500, which is one of the more diversified markets, has a current forward 12-month price-to-earnings ratio of about 14.9, which is above the 5-year average of 14.4 and the 10-year average of 14.2.

In some ways, retirees are out of luck. It’s a depressing thought, but there’s not a whole lot the average Canadian can do. We can’t simply ask the banks to raise their rates. A client can buy bonds further out on the yield curve – the 30-year Government of Canada benchmark bond yield is about 1.93% versus 0.59% for a 5-year Government of Canada bond – but if rates rise, that investment will fall. (Though, if rates do drop further and go negative, the price of that bond will climb, which would help a portfolio.)

People will buy more dividend-paying equities, but advisors should make sure that they’re buying stocks that aren’t overvalued in a significant way. Chasing yield only goes so far; you still want to own a fundamentally sound business.

Booth suggests buying preferred shares, which tend to pay more than bonds – many high-quality ones are paying about 5% today, he says. Preferred shareholders will also get paid out before equity holders if the company goes bankrupt.

In any case, advisors are going to have to get creative if they want their clients to make money in a zero or no-interest rate environment. Pre-retirees will likely have to take on more risk, whether that’s owning more stock or buying corporate bonds that have higher yields, and they may have to dip their toes more into alternative assets, such as physical real estate.

Retirees will likely have to take on more risk, too, though that’s always a challenge if they need money now. Unfortunately, Booth says that retirees don’t have a lot of options, other than holding cash or taking more risk. They can stick to bonds, but need to be aware that bond prices will rise if yields fall and rising prices will result in those securities losing value.

Essentially, advisors have to lay it all out there for their clients: It’s getting harder and harder to make money in government fixed income and savings accounts. If clients need to grow their wealth, they have to take on more risk. That’s what the government wants Canadians to do, too, he says.

“The central banks would like us to borrow to finance investment and spending,” says Booth. “Personally, I would do what the government wants us to do.”

Whether we like it or not, it’s a new world and one that doesn’t have a lot of historical context to go along with it. “This was only a curiosity seven years ago during the financial crisis,” says Booth. “Now due to the ineffectiveness of monetary policy, we’re seeing it happen.”