Negative Real Interest Rates

According to John Hempton, China’s savers are forced to save at a negative real interest rate. With US treasuries and German Bunds also below inflation, a commentator writes:

Also, that in an era of negative rates, everyone will essentially lever up as much as they can and as far out on the yield curve as possible (issuing zero coupons, ideally), and that this should always be able to soak up the excess supply of cash?

The argument for believing that they are impossible is to consider the behaviour of a commercial entity, say, Apple. Suppose that you could borrow at a negative real interest rate, then you could issue 7 year bonds at a negative real interest rate. Now presuming that you could find any assets with a nominal yield, and a maturity at the same length as your issue. So you could, say issue a bond with a maturity dated to some old US treasury that was not a coupon, and buy that. In fact, there is no price that is too high for a bond offering free money, so the bond prices for coupon paying treasuries would go to infinity.

There are many reasons to believe that the above argument is flawed. Firstly, negative real interest rates does not mean zero coupon. Moreover, who would buy a zero coupon bond? We call that cash(!). Anytime that you see a zero coupon bond being bought, it is clear that the bond has an alternative use which is valuable to the buyer. (In this case it is a repo-able collateral for the banking sector). Secondly, when macro-economists talk about interest rates they mean the fed funds rate, but very few entities can actually borrow at that rate. Thirdly, even if you could engage in the carry trade outlines above, it has an unknown opportunity cost: there may be a profitable opportunity about to come up, so even if you can borrow money at negative real rates, it might be best to do so and simply keep that money against a rainy day. If you were google, and could borrow for thirty years at one or two percent, it is almost certainly right to simply borrow that money, and wait for an opportunity to invest it.

So perhaps the above discussion has offered some useful insights:

(1) A commercial company will never be able to borrow at zero coupon.

(2) If a government bond is selling at zero coupon, it is a sign of sickness in the interbank lending markets.

(3) Negative real interest rates are bounded by inflation.

(4) Given the low levels of inflation currently predicted in the TIPS market in the US, UK, and Germany, and typical spreads on commercial bonds compared to government bonds, it is likely that there are very few commercial entities that will be able to borrow at a negative real interest rate unless there is a significant rise in inflation.

(5) High inflation makes negative real rates for a commercial enterprise possible, but it will not occur at zero coupon, and so there will be a lack of obvious carry trade opportunities (Everything higher yielding will carry more risk, exactly as it should).

One will not that I have not mentioned dividend paying shares. It is often assumed that the stock market is inflation protected, and on balance this may be true, but because of wild swings in price, it is not without risk. However, it is probably true that a company that can borrow at less than its dividend yield, could borrow and buy back its own shares, and add value. However, this is always the case. And few companies seem to do it. For one thing, bond holders get worried if the debt to equity ration is high, and hence even if you can borrow at less than dividend, you can only borrow a finite amount of money, and there is an opportunity cost associated with it. Also, dividends can be cut if the company runs into difficulties, but it is more difficult to renege on bonds. (It should be self evident that you have won on this trade only if dividend yields stay above bond yields over the whole maturity of the bond). All in all, its a risky strategy. If you are in a sufficiently strong position to attempt it, you are probably better to pay out of your cash reserves and maintaining the option to raise cheap bonds if you need them.


About worldofinterest

I know I live in my own world, but I like it: they know me here.

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