Negative interest rates are probably the most daring policy move most of us will ever see. The idea that a borrower is paid to take out a loan, but a saver is penalised for setting aside money for their retirement turns our understanding of the fundamentals of finance on its head. But Europe has had them for more than a decade. And if the experience of today’s financial crisis is anything to go by, it will do so for a while longer yet. So where does this leave defined benefit (DB) sponsors and their accountants?
- The euro-zone has had negative rates for over a decade
- IAS 19 does not say negatively yielding corporate bonds should not be used in yield curve calculations
- What investments can fill the differential between the interest and inflation rates?
The main thing to remember, says Willis Towers Watson consultant Andrew Mandley, is that there is nothing in International Accounting Standard 19 (IAS 19) that says corporate bonds with a negative coupon should be ignored when constructing a yield curve. But there are, he notes, individual bonds involved in constructing those rates that do have negative coupons. “So, you could say they do have an influence, but it is not so widespread as to make the overall discount rate turn negative yet. But it is worth remembering that we have pension increases linked to inflation and we already have significant negative real yields.”
Welcome to a world on the cusp of net present values that might one day exceed the cashflows that a scheme sponsor expects to pay out. Or will they? The thing is, despite all the talk of crisis and extraordinary fiscal and monetary policy responses, it is still not clear whether that world will ever be reached.
“But that,” says Mandley, “is no more of a paradox than central banks enforcing negative interest rates. So, in terms of how this might play out, I think by the time we are seeing negative rates under IAS 19, we would be seeing substantial negative base rates being set by central banks.”
So what does discounting currently look like? In the UK, the rate is about 1.5% to 2% against a Bank of England base rate of 0.1%. In the euro-zone, the typical IAS 19 discount rate is about 1%.
“Faced with negative interest rates,” says Mandley, “schemes would need to reconsider whether to invest in negatively yielding assets and expect an investment loss. There will be a natural aversion to this for some investors, and that might change the balance of their preference between matching their liabilities and taking risk to seek a return.”
But how low can interest rates go? Is there a floor? The answer is more complex than thinking in terms of a 200bps or so buffer before we hit that mythical zero mark, or below.
“I would refer to the long-dated treasury yield as near 1% and argue that this is floored at maybe minus 0.5% or slightly below rather than the 200bps – the 200 includes credit risk which confuses the calculation,” says Schroders solutions manager Jon Exley.
“There is an interesting discussion to be had on how negative nominal yields could become – while cash remains in circulation rates are floored at the ‘storage cost’ of holding notes and coins securely but if cash is replaced entirely with electronic money even this floor does not apply. In theory ‘real’ yields can already be almost as negative as you like.”
That is perhaps the challenge when you attempt to figure out what comes next. These are extraordinary times. They are a world away from April 1980 when those who drafted and crafted IAS 19 issued the standard as an exposure draft. Ronald Reagan was US president, Michael Jackson had just won a Grammy, and 10-year Treasury yields averaged 11.43%. Happy days.
“The more the discount rate falls,” says Exley, “the more important the longer-dated cashflows become when you are valuing corporate bonds and other securities. Back when you were discounting at 10% the longer-dated cashflows didn’t matter much, but if you are discounting at 1%, suddenly the survival of the entity becomes much more important. Other than that, nothing has really fundamentally changed. Regardless of interest rates, you are interested in the ability to earn 1% to 2% credit spread, irrespective of the level of interest rates.”
One topic that crops up in conversations about negative rates is hedging. Because, explains Mercer partner Charles Cowling, negative interest rates affect the optimal level of hedging. Although he is quick to add that Mercer encourages trustees to be fully hedged.
“Negative – or very low – rates mean that you possibly would not want to be 100% hedged. This is because of the cost of hedging and also the protections that it is providing are not matching the liabilities. So there is an optimal level that might be less than 100%,” he says.
“If your liability, for pension increases, is linked to inflation with a minimum of 3% and a maximum of 5%, but actually your expectation for inflation is considerably less than 3% – and there’s not much risk of going above 3% – you might conclude that your liability is closer to a fixed liability than an inflation-linked liability. For example, your expectation might be for inflation to stay in the range of 0% to 2% but you will still have to pay pension increases of 3% annually.”
But is there a cap or ideal maximum level? “Ultimately, you can get some diversification from not being fully hedged and from other diversified sources of return,” says Mandley, “so you wouldn’t necessarily hedge to 100% while you are still running other risk but, fundamentally, schemes need to be comfortable with what they are not hedging and what their risk exposure on that is.”
So although 100% might be considered too high, it is best to be clear on how much risk is left on the table by not hedging.
If, as the experts all agree, IAS 19 is investment-neutral in its impact on investment decisions, where do you go to find that 1% to 2% credit spread that Exley talks about?
“Anything that is too good to be true,” he says, “is being snapped up by the markets and so it is quite hard to find obvious anomalies in the pricing of assets. The trick is to try to find areas that other people have not yet moved into. One example is infrastructure.
“There is a lot of interest in long-dated senior infrastructure debt, but much less in the junior tranches which are less attractive to, say, insurance companies. So there are still some areas that other investors haven’t flocked into. You can often find better value in junior tranches per pound of risk taken than in the long-dated senior tranches that everyone is trying to get into.
“There are also areas where complexity is rewarded such as securitised credit. A lot of investors are still wary of this asset class but it is hard to find similar yields in other areas without flocking into evidently more risky areas.”
Which suggests a solutions manager might be handier than an accountant to have around if things turn seriously chilly.