This is getting really weird, or when did interest-bearing debt become an oxymoron…?

In the “olden days”, when money was borrowed (and ignoring the impact of usury laws and religious prohibitions), it was customary for the debtor to pay the creditor a rate of interest based, inter alia, on the perceived risk to the lender of making the loan, or the lender’s perception of how desperate the borrower was. To say that this was axiomatic would be understating the point.

Those of us who are old enough can, of course, also remember when even the US Treasury had to pay double-digit interest rates, even if, in real terms, the rate was much less.

Yet, now we seem to have stepped Through The Looking Glass and fallen down a Rabbit Hole into some form of parallel universe, in which one begins to wonder what “interest rate” means any more.

Economics has the concept of the Zero Interest Rate Bound (ZIRB), also called the Zero Lower Bound (ZLB), which posits that nominal interest rates (as opposed to real ones) should not become negative. This “certainty” was shattered, first in Japanese money markets some two decades ago and again in the wake of the Great Financial Crisis (GFC), in which yields on a wider range of sovereign bonds, such as Bunds, became negative. As the global economy has gradually recovered and grown since then, one would have thought that “negative yields” would have been consigned to history. However, some USD 12.5TN equivalent of debt now has a negative yield, including (according to Deutsche Bank) some USD 600BN of corporate debt. Not only does one have to process the fact that apparently all the Czech Republic’s Euro-denominated debt now trades at sub-zero yields, but also cope with the reality of even some “high-yield” bonds yielding less than zero. It is almost Orwellian doublethink when “high yield” = <0!

One can, of course, debate whether we are increasingly the victim of that old central bank and governmental favourite called “financial repression” (in a new guise), or of misguided attempts to “keep the economic music playing”. Nevertheless, the reality is that such circumstances can have strange and surreal consequences.

Consider the tale (as related by Charles Gave of Gavekal Economics) of the Dutch pension fund manager who was reminded by his regulator that he needed to reduce his cash holdings (cash being regarded as “risky” for a pension fund) and buy more long-dated bonds. When he remonstrated that, as most high-quality Eurozone bonds had negative yields, he was bound to lose money, the response was the Dutch equivalent of: “Them’s the rules”. Perhaps even more surreal is the idea of Danish mortgage lenders offering borrowers a mortgage that pays the borrower interest.

Look at the world from the point of view of a life insurance company. If it is forced to lock in a negative yield on increasing components of its Invested Assets, what steps can it take to mitigate this embedded risk to its P&L and capital accounts? Raise its premiums, scale back business, or go hunting for assets that do actually demonstrate a reasonable chance of generating a positive interest return? None of this is straightforward.

Such an environment will favour those who are able both to think through the consequences beyond the first order, and can understand and manage the risks and opportunities that it poses and offers; because, where there is risk there is usually opportunity.

The Awbury Team


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