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Negative interest rates – diving into the unthinkable world below zero

Waking up in a house you own free and clear, with any mortgage fully paid off, is a dream for most of us these days. But what about waking up in a house that pays you to own it?

This month one of Denmark's largest banks, Jyske Bank A/S, has rolled out a negative interest rate mortgage, offering qualified homebuyers the opportunity to take out a 10-year loan at -0.5%. This mortgage effectively pays a borrower to take money from the bank: if you borrow $1 million your repayment cost will be $995,000. By way of comparison, a 15-year fixed rate mortgage in the US for the same amount at 3.4% with $40,000 down would take $1.26 million to pay off in full.

Welcome to the world of negative interest rates. Once considered an anomaly, they are becoming more and more common. We have already seen negative interest rates in Japan and Eurozone. The German government debt yield curve is currently under zero up to 30-year Bunds. Globally, the total supply of sub-zero yield is currently estimated at around US$16 trillion. (Figure 1).

How are investors reacting to this extraordinary rate climate? How are fund flows evolving? EPFR data can provide reliable, evidence-backed answers to these pressing questions.

Figure 1 and Figure 2 bring together the total supply of negative rated bonds with cumulative flows to EPFR-tracked bond and equity funds. You would anticipate investors fleeing from bond funds, as more and more bonds offer negative yields, and shift their money into equity funds as the cost-of-capital falls. But what you would expect in this situation is not what you are getting.

Surprisingly, as one can see from Figure 1 and Figure 2, the increased supply of negative rates coincides with period of increased flows to bond funds and outflows from the equity funds.

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[Figure 1 - Cumulative Bond Flows and Global Supply of Negative Yielding Bonds]

Source: Bloomberg Barclays, EPFR

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[Figure 2 - Cumulative Equity Flows and Global Supply of Negative Yielding Bonds]

Source: Bloomberg Barclays, EPFR

This interesting phenomenon might be due to:

- Decreased risk appetite –The periods which show an increase in negative interest rates coincide with fear of secular stagnation / slower growth / lower inflation etc. This triggers a rotation to bonds – even if they are negative-yielding -- because investors expect to lose less money (or even make money) in bond funds compared to equity funds.

- Chasing the Return - Falling yields mean capital appreciation for bonds, even when the carry goes negative, so investors may be chasing positive returns in the short term.

To dig deeper into the tendencies of investors during similar periods, we inspected other periods when there was a surge in the amount of debt offering negative yields. Table 1 lists cumulative flows (as a % of AuM) for selected fund groups between August 2015-August 2016 and the recent period between October 2018- August 2019.

This table shows that there are significant similarities between the two periods. For one, the most significant inflows during both periods went to US Investment Grade, US Long Term, and EM Hard Currency Bonds Funds. Additionally, we have seen increased flows to Japan Equity Funds and, we witnessed outflows from the US, European, and Asia ex-Japan Equity Funds in both periods of time.

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[Table 1 - Cumulative Flows to asset classes: August 2015-August 2016 vs October 2018- August 2019]

Source: EPFR

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[Figure 3 - Cumulative US Long Term Bond, EM Hard Currency Flows and Global Supply of Negative Yielding Bonds]

Source: Bloomberg Barclays, EPFR

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[Figure 4 - Cumulative US & Europe ex-UK Equity Flows and Global Supply of Negative Yielding Bonds]

Source: Bloomberg Barclays, EPFR

The differences between these periods reflects a change in global economic circumstances. During the current period we aren’t seeing inflows into US High Yields Funds. Instead, we see money into US Short Term Bond Funds, reflecting increasing caution about towards credit risk in the US which is in line with the general fear that a US recession is likely by the end of next year. Plus, we see inflows to EM Local Currency Bond Funds, as the increasingly dovish stance of developed central banks is helping EM currencies.

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[Figure 4 - Cumulative US High Yield, EM Local Currency Flows and Global Supply of Negative Yielding Bonds]

This raises an obvious, but important, question. Are these flows to EM Bond Funds (both hard and local) sustainable in a low-growth world? Is this just an outcome of the return chasing behaviour of investors? Is it strategically correct to hold on to this asset class, or is it just chasing momentum?

In the past two weeks we have seen above average flows into South Africa Bond Funds. South African debt is certainly risky – its investment grade credit rating hangs on one notch by one agency away – but the average yield on a 10-year note is 8.4%. If flows to this, and similar, fund groups hold up it will provide important evidence that falling yields in the developed world have increased the incentive to hold risky high-yield credit, thereby making it a strategic asset class.

If, however, these flows fade, and investors step up their pursuit of short-term gains from the easing cycles in developed markets, investors will have a much clear sense of which asset classes are being viewed as tactical when their peers make their asset allocation decisions.

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