While playing bocce ball the other night, a friend asked me what my impressions were of negative interest rates and why anyone would deposit money into a bank that had negative interest rates. Alongside of us was another friend who, like many people, had never heard of negative interest rates but was able to surmise that it had something to do with a negative sign in front of the interest rate.
If you are unfamiliar with this concept, you may want to be aware of the potential risk because negative rates are spreading. Right now, for example, investors will find negative interest rates on government bonds from Germany, France, Japan, Sweden, Denmark, among others. Likewise, many of their banks are paying negative interest rates on deposits.
When you invest your money into an interest-bearing account at the bank, you expect to receive interest income. But what if the bank did not pay any interest at all? What if the bank charged you interest to hold your investments? That would be an example of negative interest rates. In other words, if the bank was offering an account with negative 1% for the year, it would mean the bank would charge you 1% for one year.
Investors accept negative interest rates because they believe it is the least worst investment option available to them. If you are worried about potential major losses in stocks, real estate, and commodities, then accepting a negative 1% might not be so bad. Why wouldn’t investors withdraw the money and put it into a safety deposit box or bury it in the backyard instead of losing money on an investment with a negative interest rate? There are a number of reasons withdrawing cash would not be practical including the amount of money involved, the risk of theft, the inability to quickly transact business, and the money might be in an IRA or retirement plan.
Countries across the globe are facing slowing economies. In order to encourage investments into new businesses, stocks and real estate, these countries have implemented policies that include negative rates for safer investments. In other words, the governments want to strongly encourage investors to purchase riskier assets that could help their economies grow. However, a lot of investors do not have confidence in those countries. Thus, they accept negative rates or look to buy investments abroad such as U.S. stocks and bonds.
Funds leaving foreign countries and being invested in the United States has helped strengthen demand for the U.S. dollar. Our government is still paying a positive rate of interest on its bonds, the bonds are secure, and are very liquid. The high spread between the rates of U.S. bonds and many foreign bonds is partly why President Trump feels there is room for the Fed to lower rates. The free markets seem to agree as investors have poured money into bonds in anticipation that the Fed will eventually lower rates.
If you are investing for income, there are ways to protect your income from declining rates. Diversification is the key, and you might consider investments into dividend-paying stocks, income producing real estate and real estate investment trusts, annuities designed for income, long-term bonds, preferred stocks, among others. Each alternative has its own merits and risks. I don’t believe the United States is anywhere near having to pay negative interest rates to encourage investments. Nonetheless, interest rates could fall further, especially in the event of a recession. So, know your options, diversify, and work with an advisor who can help you manage risk.
Ken Levy is a financial advisor with, and securities and advisory services offered through LPL Financial, a registered investment advisor, Member FINRA/SIPC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Investing involves risk including loss of principal. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.