This week, a friend of mine sent me an article she felt I might find interesting. Actually, calling it an article might be a bit of a stretch, as it wasn’t much more than a few hundred words. However, it was enough of one to warrant its own headline, and what a headline it was: Alan Greenspan says it’s ‘only a matter of time’ before negative rates spread to US. That is exactly how it appeared at the top of the page.
She wanted to know whether I agreed with the former Chair of the Federal Reserve, and I expressed some surprise the man is still alive, somewhat tongue in cheek. After reading the former Maestro’s comments, I think the headline might be a little stronger than his actual sentiment. Yes, he believes the United States will eventually have negative interest rates. However, it will require a change in American risk tolerance before it happens, which he believes will ultimately occur.
Here is a snippet which touches on his point:
“We’re so used to the idea that we don’t have negative interest rates, but if you get a significant change in the attitude of the population, they look for coupon,” Greenspan said. “As a result of that, there’s a tendency to disregard the fact that has an effect in the net interest rate the receive.”
In truth, I have seen this for years, long before we ever envisioned negative yields and the like. Here is the way it works. Imagine Investor X has $1 million to invest, and wants/needs to generate $50,000 in annual income from the investment. Further, they want to take very little credit risk, nothing fancy or clever, and don’t want to buy anything longer than 10-years to maturity. The only problem is, 10-year paper is currently yielding, say, 3% in this example. If you have worked in the investment industry for any length of time, you have undoubtedly ‘run across’ this scenario any number of times.
In these instances, I have always preached ‘total return,’ which is a combination of income PLUS principal appreciation. In a 3% world, a 5% return will require taking on some unintended or undesired risk, of some sort. As such, Investor X either needs to adjust their return assumptions OR increase their risk tolerance, often both, and I have been known to turn away prospects who are insistent on unrealistic expectations.
However, what Greenspan is alluding to is investors often confuse coupon return with total return. After all, I can generate $50,000 in annual income on a $1 million investment with the best of them. However, it requires a little, um, creativity, if that is the right word.
After all, Advisor F can purchase a fixed income investment at a premium which will generate the necessary income stream. For instance, there is an old US Treasury long bond still floating around the 10-year area with a 6.125% coupon, maturing on 8/15/2029. Today, and I mean quite literally today, the price of this security would be $126.66715 at a 3% yield to maturity. Advisor F would be able to purchase a par value of 787,000 of the things for $1,000,141.76. This would include $3,274.71 in accrued interest. So, the math is like this: 787,000 * 0.06215 = $48,203.75/annual income. This would probably be ‘close enough’ for most folks.
But, hey, you don’t get much better than a US Treasury, right? 10 years in final maturity generating almost $50,000 in annual income on a $1 million investment? Slam dunk, right? Well, as Lee Corso might say: “Not so fast, my friend.” After all, Investor X will only receive $787,000 when the security matures roughly 10-years from now. If THAT is okay, so be it. Most folks don’t like it when they finally realize it. In fact, I once had an older woman get angry with me when I explained the math to her after she showed me her brokerage statement from another firm.
“What does that even mean what you just said? That I paid my principal out as income over the years? That doesn’t make any sense! You say I am only going to get that amount when the bond matures? But I paid this amount for it! Don’t you know how this works. You get your money back when a bond matures!” She left in a huff pretty soon thereafter, and I haven’t seen her since.
The thing is, I DO know how bonds work, and so did her advisor. However, she didn’t. She heard the income stream she needed, and green-lighted the purchase. THIS is to what Greenspan was referring when he said: “…but if you get a significant change in the attitude of the population, they look for coupon.” Basically, some folks will, and do, only focus on one aspect of total return: income. My experience suggests he is absolutely right.
So, negative interest rates in the United States? Greenspan thinks it will eventual happen, as long as the income stream on the securities in question is positive. Taking it one step further, he assumes the huge Baby Boomer Generation will eventually focus on income to the detriment of the underlying principal of their portfolios. Yes, the bond might generate a 3% income stream, but you will have to pay, say, $125 for $100 in maturity value.
I can’t stress this enough: in a 3% world, you won’t make 5% without taking on risk. Period. In a 0% environment, even a 3% return will require a change in tolerance. Finally, you guessed it, in a (1%) market, making 2% will mean putting your principal at some form of risk: interest rate, credit, liquidity, or even ‘maturing at par’ risk. With this in mind, people can be counterintuitive.
You see, there is some sort of solace in the assumed ‘risk-free’ rate, usually some form of sovereign debt security for domestic investors. I suppose the thought process is something along the lines of: “hey, at least I know I am getting something back. I would rather have 95% of my money than 100% of none of it, if you catch my drift.” Hey man, I get your drift, but I repudiate it.
I have an extremely difficult time understanding why an individual investor would knowingly invest in a security which guarantees a loss. An institutional fixed income investor betting on the direction of interest rates? An insurance fund or bank portfolio which is legally required to buy a certain type of security? A pension plan matching up assets and liabilities? Okay, I can wrap my head around that. But Individual Investor X? No, man…no. Put currency in your safe-deposit box. Certainly, some bank deposit account will pay you 0%. That is only if you want your money to do nothing. Who wants that?
To be sure, it can and might happen in the United States, negative interest rates. Baby Boomers might become focused solely on coupon, and disregard the maturity value of their investments. Investors from Nome to Miami might just come to expect nothing from their investments, and accept a global economy spinning slowly down to die. I and we won’t.
IF the US investor becomes so risk-averse as to drive domestic interest rates structurally into negative territory, if that happens, risk will be so out of favor it will be cheap. At that time, there WILL be home runs to be had, triples for the stealing, and doubles littering the diamond. We will gather them up for our clients and ourselves, even if we have to tell them to push out their time horizon a couple of years.
So, negative interest rates in the US? Hey, when the risk-free rates of return lock in a loss, it will be time to take on some risk. What do you have to lose but some money, which you were guaranteed to do anyhow? Think about it.
Just a thought and a little more bravado than usual on a Friday…anything to argue the opposite side of Alan Greenspan.
Have a great weekend.