Common Cents & Negative Interest Rates on July 26, 2019

July 25, 2019, by John Norris

About 20 years ago, I was a groomsman in the wedding of one of my miscreant friends. A few years prior, he could have said the same about me. For the guys’ weekend, as I hesitate to call it a bachelor party, we went to Atlantic City. At the time, I had been to a few casinos, a very few, and had only played the up to $10 blackjack tables and the slot machines. To say I was coming into town riding on the proverbial turnip truck would be an understatement.

Even back in the day, I would have had an easier time painting the Mona Lisa with a box of crayons than finding a $10 table on a Saturday night in Bally’s, I think it was. One simply didn’t exist, and the lines at the $20 tables were several deep. So, when in Rome and all of that, I got in the queue.

As I watched the action, if you can call it that, I noticed how players threw green pieces of paper at the dealer which had pictures of either Andrew Jackson or Benjamin Franklin on them. In return, they gave them back little plastic chips. I also noticed how the waitresses seemed to get more booze for the people who put down the most money.

Hmm. Turning cash into plastic discs which were worthless outside the casino? Plying folks with increasingly amounts of booze the more they bet? Then it dawned on me, and you can call me stupid if you want. As though a lightbulb went off inside my head and a veil had lifted, I suddenly realized everything about that place, and every drop of energy exerted, had one goal: to separate me from my money. What’s more, it would do so if only I stayed long enough.

I didn’t stay, at least not to personally gamble, and that is the operative word: gamble. According to Merriam-Webster, definition 1b of the intransitive verb usage of this word is: “to bet on an uncertain outcome.” Interestingly, in Las Vegas, each hand you play is a gamble. However, the longer you stay at the tables, the sum of each individual gamble is a foregone conclusion: handing your money over to the casino owners. As such, if the end outcome of casino gambling is a certainty, is it really gambling? If not, could we call it a ‘sucker’s bet’ at the least?

The same could be said of buying bonds with a negative yield to maturity, or what the media is calling ‘negative interest rates.’ After all, any individual investment is a gamble, to some degree. However, one in which the individual investor is guaranteed to lose money, in absolute terms and if they hold it to maturity, is a sucker’s bet.

Currently, Bloomberg estimates some 30% of tradeable global government bonds have a negative yield to maturity. For all intents and purposes, this effectively means you are paying the local government issuer to hold your money. Put another, a negative yield to maturity is when the sum value of your interest payments and the final return of your principal is LESS than what you originally paid for the investment.

For instance, this morning, the 10-Year Swiss treasury debt security had a yield to maturity of -0.737379%. It matures on 6/22/2029 and does NOT pay any interest; it has a 0% coupon. As I type at 10:34 am CDT on 7/25/2019, the offer side is $107.600. This means in order to buy a bond which will maturity in a little less than 10 years at $100,000, it will cost you $107,600 today.

Who would buy such a stupid investment? In a very good, concise article from The Economist magazine in February 2016 by ‘Buttonwood,’ the largest group of buyers almost doesn’t have a choice, if that makes any sense. Instead of me rephrasing an excellent paragraph, let me cut & paste it here:

“The first (group) is those investors who have to own government bonds, regardless of the financial return on offer. This category includes central banks, which holds bonds as part of their foreign exchange reserves; insurance companies, which need to hold bonds as part of their reserves; pension funds, which own bonds to match their liabilities; and banks, which need government bonds to meet liquidity requirements and also to pledge as collateral when they borrow in the money markets.”

Perhaps not surprisingly, this makes up the bulk of purchasers.

The second group would be fund managers and other, arguably more clever, investors which are betting more on currency fluctuations and future inflation rates than on the nominal return of their investment. For Instance, Investor X thinks the Swiss franc will appreciate. So, they buy the Swiss 10-Year at -0.737% to hedge against the relative decline in their domestic currency. Other investors might believe there will be a decline in economic activity and inflation, which will give even negative yielding securities a boost. Essentially, this portion of this group believes deflation might be greater than the negative return on their investment in absolute terms. Interestingly, this would make it a good relative investment.

The final group is made up of, well, investors who would rather accept a relatively small, known loss than “to bet on an uncertain outcome.” In other words, gamble. Without having any numbers in front of me, I would imagine this is the smallest of the three groups The Economist outlined. Perhaps I am too much of an optimist. Maybe I am too American. I could be I have been doing this too long. However, I can’t fathom why a ‘buy & hold’ individual investor would sink their money into an investment which is guaranteed to lost them money IF they hold it to maturity. That type of bunker mentality doesn’t make any sense to me.

After all, IF you are so negative on the prospects for return in your local economy that you would willingly accept a loss, why wouldn’t you find someplace else in which to invest? Find a fund which invests in assets denominated in another currency? Leave it in a checking account at 0%, which you should be able to find? Heck, buy a fire-proof safe for the house or pay a nominal fee for a safe-deposit box in which to put currency? Put it in a coffee can? Heck, buy a darn utility stock or something which people ‘have’ to have regardless of the economic situation? Beer stock? Lipstick manufacturers? Cigarettes? Companies like Kraft or Nestle? Anything?

In essence, an individual, retail investor buying a bond with a negative yield to maturity is like the average Joe walking into a casino. They are both sucker’s bets, as they both lose money if you just do it or hold it long enough. It isn’t investing and it isn’t even gambling. It is willingly accepting a loss.

Of course, there are undoubtedly so-called experts who might disagree with that last paragraph, and might even make sense in theory. However, these would be the same people who believe the proverbial Widow Jones really cares what the Sortino and Treynor ratios are on their portfolio. More? These are the same folks who can tell you the maximum amount of torque a particular bolt or screw can take but not how to actually use a screwdriver. I think I wrote that correctly.

So, in the end, if gambling is betting on an unknown outcome AND the outcome is known to be negative, why would you do it IF you had other options available to you? That is a great question, and one I would have to ask individual investors willing to buy long-term bonds/notes with a negative yield to maturity. Central banks, banks, and pension plans? I understand there are statute limitations, liquidity requirements, and asset/liability matchups…all of it. So, I get the overall demand for ‘negative interest rates.’ I do, as some investors are simply stuck having to buy what is available. Others, like retail investors with no such constraints or requirements? I don’t get it.

In the end, and in my opinion, individual investors would be much wiser to ‘gamble’ on investments where the odds are in their favor rather than locking in an absolute loss with a negative yielding security. Why? The best return it can generate is a RELATIVE return over the long haul, and I have yet to figure out how to fold a relative dollar. I can only do so with the absolute ones. So, in that regard, meaning absolute return, locking in a negative one is, again, a sucker’s bet.

With that in mind, it is also the reason why I don’t go to casinos.

Have a great weekend.

 

John Norris