Low Rates Changing Asset Class Risks

In our current low interest rate environment, the traditional economic theories of what constitutes a safe vs. risky asset is changing. Traditionally bonds were considered a safe haven, providing income and safety of capital. However, central bank stimulus policies have resulted in low, and in many cases, negative yielding government bonds. As of early July, the total outstanding negative yielding government debt is now over $13 trillion. What was once thought unimaginable is now becoming common place. Switzerland has sold bonds that mature in 2058 at a yield of negative 0.023%. So after 42 years of ownership you will get back your capital, minus 0.023%, and nothing else. No coupon payments. Yikes.

But at least the capital is safe right? Well, if you plan to hold on to your investment until maturity, then yes. But even the best laid plans can change, and if you have to sell prior to that you could be in for a wild ride. If interest rates were to go up to 2%, these bonds would be worth around 45% of their face value. That’s worse than equity risk, provides no income, and doesn’t even account for the deterioration of your capital due to inflation. Now this doesn’t mean you should avoid fixed income investments. They are a pillar of building a well balanced portfolio, and should not be left out. To avoid the interest rate risk noted above, try moving your bonds to the shorter end of duration. This makes bond prices more stable, while not giving up much in the way of interest payments.

Now to be fair, we are not likely to see 2% interest rates anytime soon. Global growth is slow, and central banks are taking a very cautious approach to monetary policy. However, 2% rates are not beyond the realm of possibility. Historically speaking even 2% would be considered quite low. But history is made to be rewritten, and it feels like the pen will stay on the page for a while longer.

http://www.wsj.com/articles/germany-sells-10-year-debt-at-negative-yield-1468410101

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