Here’s my summarised rendition of a conversation that I keep having about negative interest rates:
[Other Person] The world though, amirite?
[Me] What about it?
All these f-ing negative interest rates. I mean, where are you meant to put your money?
Um… I don’t follow. What do you mean?
Geezlike – aren’t you meant to be this finance blogger though? Neg-a-tive in-ter-est rates.
Yes, I’m aware of them…
Yes, well, then, if you are – then where are you meant to put your money?
Well, that depends, I guess. Shares, unit trusts, REITs. You’ll want to keep some money in the bank, of course…
[interrupts] IN THE BANK?
BUT WHAT ABOUT THE NEGATIVE INTEREST RATES?
[Confused] What about them?
WHY WOULD YOU PUT YOUR MONEY IN THE BANK IF THEY CHARGE YOU FOR IT?
Um – I’m not sure that we’re talking about the same thing. Do you know what most people mean when they talk about “negative interest rates”?
Of course I do. It’s when the bank charges you for the pleasure of holding onto your money.
Right. Well – yes, I agree that we’d definitely call that a negative interest rate. But that’s not what most people mean by “negative interest rates”. I think they’re talking about negative bond yields.
Let me ask a question: do you know what a bond yield is?
It’s the effective interest on a bond.
Exactly. So when a government or a corporate wants to sell a bond to raise money, what it’s actually doing is auctioning off a set of future cash flows. They say to the market: “Here’s this 10 year bond with a face value of $1 million and a coupon rate of 2%. So we’ll pay you $20,000 a year in coupon payments for 10 years, and then we’ll also pay you $1 million at the end of the tenth year. How much will you pay us for this?” And then the bond goes to auction, and people bid for it. With me so far?
So if people bid $1 million for it, then the ‘yield’ or ‘effective interest rate’ on the bond would be 2% – because the coupon rate and the yield are exactly the same. And if people bid less than a million for it, then the yield would be a bit higher. Agreed?
But now let’s say that people are really panicked about the chaos in the world, and they just want a safe place to keep their money, and they believe that this particular government is a sure bet. Do you think that they might pay a little more than $1 million for the bond?
Well, that would push the yield below 2%.
And if the price continued to go up, once it passed the total of all the future cash flows combined, then the yield turns negative.
So in this case, if you paid more than $20,000 times 10 years, plus $1 million, so …[calculates]… if you paid more than $1,200,000 for the bond, then the yield on the bond goes negative.
But why would you ever do that?
Well, for safety. It’s a bit like asking “Why would you pay for insurance?” You don’t always invest for gain – sometimes, you just want to not lose anything. Or, rather, you’d prefer to take a small guaranteed loss over a massive potential loss.
But it doesn’t always have to be that way. Let’s say that you paid $1,250,000 for that bond we were talking about, meaning that bond now has a -0.44% yield. Perhaps that sounds like a bad investment – but what if you buy it because you’re expecting more panic in the future? And say that when you sell the bond, you sell it for $1,300,000. Would you have made a $50k profit?
So there are times when a negative yield isn’t that important. For instance, when you’ve got Quantitative Easing policies on the go – and you’re expecting bond prices to rocket through the roof.
So what’s your point?
My point is that those are the negative interest rates that are generally in the news. They’re actually negative bond yields.
Also, I’ve made it sound like this is something that only happens when governments or corporates first issue the bonds. But the reality is that most of the negative interest rates have come about long after the bond was first issued. These are just bonds being traded between bond investors for really high prices. The people ‘making losses’ are whoever ends up holding the bond to maturity.
It’s basically bond investors trading losses between themselves – the government/corporate in question will still end up paying the original coupon rate in exchange for that money that they received in the initial auction.
But that’s not what I’ve heard. I’ve definitely read about banks charging negative interest on deposits.
So that’s true. There are a few Central banks in the world that have started charging the retail banks for deposits. Denmark, Sweden and Switzerland… Those are the ones that I can remember off the top of my head. But remember that those aren’t retail banks – those are central banks. They’re trying to ‘penalise’ the retail banks for taking too many deposits. And in turn, some of the retail banks will pass on that cost to their depositors.
So you see now. Why would you put your money in that kind of bank? A bank that charges you interest, instead of the other way round?
Well, I think that’s exactly their point. Those countries have had their banking system flooded with foreign investor money. It’s caused their currencies to strengthen, which has made them uncompetitive. So they’re trying to discourage that money from coming in.
But doesn’t that mean that normal people-on-the-street in those countries won’t want to put their money into bank accounts?
I mean, I’ve never been there, so I don’t really know for sure.
But my guess is: they probably don’t really notice. I think it’s easy to get too carried away with ‘negative interest rates’ as though they’re this really bad thing for normal people. But I think they’re quite normal.
Here’s another different question: do you pay bank charges?
So how is that different from ‘negative interest’?
Well, for one thing, it’s not based on the amount of money in my account. It’s just a fixed charge. And if I keep the balance in my account high enough, than those charges are often waived.
Okay, but in practice, most people don’t keep a stack of cash in their bank accounts. They’ll keep enough in there to cover a few months’ worth of expenses (if they’re lucky) and/or they’ll have a credit card for emergencies. Then they might keep a bit in something that’s easily accessible, like a fixed deposit or some kind of money market fund. And the rest will be invested somewhere. Perhaps in a mortgage bond, if you’re buying a house. Or in unit trusts. That kind of thing.
So when you actually look at it, most people will end up paying bank charges.
Let’s take you as an example. The fact that we’re having this conversation suggests that you’re just enough of an MBA/CA/CFP/CFA person that you might have an Investec Account. Those bank charges are R300 a month.
Now I’m assuming that you’ll get somewhere between R40k and R50k into your bank account each month. Within days, your debit orders will go off, and you’ll pay off your credit card, and you’ll be left with ±R15k in your account. In a good month. Right?
Sometimes less. I don’t keep too much in that account.
Well let’s work off R15k – which will then whittle down to maybe R3k or so before you get paid again. So let’s say, on average, during the month, you’ll have about R8k in that account.
If you pay R300 in bank charges, then that’s effectively interest of -3.75%.
But I don’t see you withdrawing all your cash from the account and closing it…
Well, no, but…
Yes, I know. Because you need a bank account in order to be able to have a mortgage and a credit card. You also need it to pay tax and to get paid a salary. To say nothing of the fact that your money is a lot safer in a bank account – think of the security risk you’d have if you kept all that in physical cash. And all the security costs!
But either way, you’re effectively being charged for the pleasure of having that bank account – irrespective of whether there is money in there. Which is basically like a kind of floating negative interest rate.
But even so – if the balance is high enough, I’ll earn enough interest to cover that bank charge, and then I’m not in negative territory.
Well, if we’re honest, you’ll still probably be in negative interest rate territory. Not too many banks are in the business of offering positive real interest rates on savings and checking accounts. Once you throw inflation into the mix, most people are losing money by keeping their money in the bank – regardless of how big their bank balance is.
It’s why most people don’t have massive bank balances relative to the size of their investments. Most of their ‘wealth’ will be held in other forms (shares, bonds, etc).
[getting annoyed] Look man, I don’t think you understand. Negative interest rates put the entire fiat money system in jeopardy.
I’ve heard people say that. I just haven’t had someone explain how though. It seems like we’ve all effectively had negative interest rates on our ‘fiat’ money forever?
But isn’t that an outrage? We should never have left the gold standard!
[argument descends in a very different direction]
The point is, I don’t think that negative interest rates are as terrible as they sound. At the very least, they’re not designed to tip us over the edge into unbridled financial chaos.