What are negative interest rates?

Typically, a central bank will have a reference or benchmark interest rate, sometimes known as the headline policy rate. It determines the rate at which banks can borrow or deposit cash with the central bank.

A negative interest rate means banks are charged when they deposit money at the central bank as part of their regular banking operations. It’s like a penalty for banks and is designed to encourage them to lend to businesses and consumers, get money moving in the economy, and fuel economic activity.

The same principle applies for investors buying negative-yielding bonds: They, like banks, are paying for the privilege of lending. A bond with a negative yield means that the interest and principal payments the investor collects as the bond matures collectively are less than the price of the bond when it was purchased.


Which central banks have set their rates below zero?

Over the last few years, a number of central banks have moved into this negative territory—the European Central Bank, the Bank of Japan, Sweden’s Riksbank, the Norwegian central bank, and the Swiss National Bank. This is new ground for central banks.


Does this mean people have to pay money to deposit in their local bank?

Not necessarily. Many commercial banks are reluctant to pass on negative interest rates to deposit accounts. But negative rates have affected some assets. Many short- and intermediate-dated bonds issued by European and governments and Japan now have negative yields.

Investors are now effectively paying governments for the privilege of lending

Yield curves for government bonds in six major markets


Investors are now effectively paying governments for the privilege of lending
Source: Vanguard calculations, based on Bloomberg data as of May 13, 2016.

Does this mean governments can borrow at negative interest rates?

The rate that governments must pay to borrow is determined by the yield curve, which mainly reflects expectations of future policy and economic conditions. If policy rates are expected to stay (or become more) negative, shorter-maturity government bond yields will be negative.

Additionally, the demand for certain bonds, even those with longer maturities, in the secondary market has been strong enough that the quoted yields on many non-U.S. government securities—already low given current policy and economic expectations—have crossed into negative territory.

Governments are not necessarily getting the full benefit of these negative borrowing costs. The negative interest rates mean that the yield on bonds in the secondary market is negative, but the interest rate may have been positive when the bonds were issued. But for any government issuing new short-dated government bonds (like Germany), investors are now effectively paying that government for the privilege of lending it money.


Why are central banks setting negative interest rates?

Central banks are usually tasked with keeping inflation at some target—around 2% for the United Kingdom, the euro area, and the United States. When inflation falls below target, usually because the economy is running below full capacity, central banks will typically lower their policy rate to encourage firms and households to borrow and spend money. Higher demand boosts growth, which puts upward pressure on wages and prices, helping inflation return to target.

The fall in demand has been so severe since the financial crisis and subsequent recession that, even though interest rates were cut to zero, inflation has stayed well below target. In some regions, this has prompted policymakers to go beyond zero and move interest rates into negative territory.


Is there a limit to how negative rates can go?

In theory, yes. One would not expect anyone to want to hold an asset with a negative yield if they can also hold banknotes (or even zero-yielding deposits in a bank account) as an alternative. After all, physical cash’s yield of zero would seem to be superior to any negative yield.

In practice, the return on physical cash is negative, too, especially for large sums of money, because it is inconvenient to hold large amounts of cash (think of storage costs, risk of theft, etc.). So that explains why it is possible for policy rates to move into negative territory. But if rates were to go too negative, the incentive to cash in would take over, which puts a practical floor on how negative they are likely to go.


Will negative rates boost the economy?

The effect of negative rates on economic activity will depend to a large extent on how these rates are passed on to firms and households through borrowing and lending rates by banks. There is some evidence that this pass-through mechanism is impaired at negative rates because banks are reluctant to charge negative deposit rates to customers, so banks are less likely to cut borrowing rates. This transmission channel may be rather ineffective in boosting activity.


How might negative rates boost inflation?

Perhaps the most direct way that negative rates affect inflation is by weakening the currency. There is some evidence that negative rates have caused the euro to weaken, for example. But of course, if lots of central banks use this policy at the same time, this competitive devaluation becomes counterproductive.


Why would an investor want to hold a bond with a negative yield?

Some institutions don’t have a choice—for example, insurance companies or pension funds that are matching their liabilities. But for individual investors, it’s important to remember why they hold bonds in their portfolios. Bonds provide stability by lowering volatility relative to equities. They act as a counterweight because, usually, bond prices rise and offset share-price declines during stock market downturns.

Granted, negative-yielding securities are unlikely to provide the same type of offsetting returns that have been experienced in the past, but the same can be said of historically low, but still positive, yields, such as what we see in the United States and the United Kingdom.

There is an extra wrinkle for investors with positive domestic yields. Through currency hedging, the yields of international bonds look more like domestic yields. While there are several factors to consider in hedging international fixed income, one result is that now the “currency-adjusted” yield on international bonds for U.S. investors is positive. The exact opposite is true for Japanese and European investors, however.


Should investors switch to hold physical cash?

It is true that there is no explicit charge to hold physical cash, i.e., banknotes. And by increasing cash’s share in the portfolio, this undoubtedly serves to dampen volatility. But unlike bonds, it provides no counterbalancing effect in a portfolio when equities fall. Furthermore, investors should not ignore the inconvenience, costs, and risks associated with holding large amounts of banknotes.

In practice, especially because central banks are aware that negative rates cannot be pushed too far, it is difficult to think of realistic circumstances when it will be worthwhile for investors to switch any of their portfolio into banknotes.


What about buying positive-yielding long bonds instead?

Alternatively, investors may want to extend the duration of their bond portfolio by concentrating on positive-yielding long bonds. Of course, this will increase the portfolio’s term risk and expose the portfolio to more downside risk when interest rates rise.


What should investors do?

For most investors it will still be appropriate to carry on holding a diversified portfolio, which includes negative-yielding bonds. The main point here is that investors need to consider any changes in their portfolio in the context of their overall long-term investment objectives.


Notes:
All investing is subject to risk, including possible loss of principal.

Past performance is no guarantee of future returns.

Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

Investments in bonds issued by non-U.S. entities are subject to risks including country/regional risk and currency risk.

Currency hedging risk is the chance that currency hedging transactions may not perfectly offset a fund’s foreign currency exposures and may eliminate any chance for a fund to benefit from favorable fluctuations in those currencies. Funds will incur expenses to hedge their currency exposures.