Investing in International Bonds, Despite Negative Yields

Just over 10% of international bonds are experiencing negative yields right now. Some investors hear this and think they should sell or avoid international bonds altogether because it must mean that they will lose money instead of make money. That is not the case.

How money moves in an economy.

To understand negative yields, you need to understand how important Central Banks are to the financial markets. I have written about what our country was like before we had a Central Bank, and it wasn’t pretty. In the U.S. the Central Bank is the Federal Reserve, in Europe it is the European Central Bank (ECB), and in Japan it is The Bank of Japan (BOJ) or Nichigin.

While Central Banks have a variety of roles, one is to keep the money in the economy moving. During times of uncertainty, or a recession, money freezes as people and companies stop spending and take on less risk. This lack of investment and new business makes it harder for the economy to recover. The Central Bank can use different tools to help spur growth, helping the economy heal faster. One of these tools is to adjust the federal funds rate target.

The federal funds rate is the interest rate that banks and credit unions earn on their excess cash reserves. When you open and fund a savings account at a bank, the bank is not actually holding your money. They lend it out to companies or customers for business, car, or home loans. Banks earn interest on those loans so that they can turn around and pay you interest on your savings account.

If it makes you worried that banks are lending your money out, it shouldn’t. They are highly regulated and have certain cash reserve requirements. Because a bank’s assets and liabilities are constantly changing, there may be times after a large amount of customer deposits, for example, where the bank has more than their reserve requirement. When that happens, they can keep the excess reserves at their Central Bank or lend it out to other banks that are short on their reserve requirement, earning an interest rate (the federal funds rate).

Central Banks in many developed countries are imposing negative interest rates.

When the Central Bank lowers the federal funds rate target, that is often translated in the media as “The Fed (Federal Reserve) lowered rates.” The Central Bank does this to jumpstart the economy by encouraging banks to lend out their reserves instead of sitting on them. While we have seen low rates before, negative rates, as we are seeing now in Europe and Japan, is very new. Negative rates mean that banks have to pay to keep excess reserves at their Central Bank instead of earning interest.

The hope with going negative is that it will be a much stronger incentive for banks to lend money out to help people start businesses, spend, and stimulate the economy. The first country’s Central Bank to impose negative rates was Sweden in 2009. The ECB and Germany’s Central Bank imposed negative rates in 2014, and the BOJ in 2016. It is too early to tell if these negative rate policies work, but this is something that economists are currently researching and debating. As an investor, your focus should be on whether negative rates impact your portfolio.

A negative federal funds rate has an impact on bond markets.

While the federal funds rate seems unrelated to us as investors, it is actually an extremely important indicator for the broader bond market. What is happening now due to a negative federal funds rate is that investor demand for short-term government debt has increased, which is increasing those bond’s prices and lowering their yields. Corporate rates are linked to government rates so they are experiencing the same movement.

A negative bond yield does not translate into a negative return.

While you may assume that international bonds underperformed higher yielding U.S. bonds, the opposite is true. Bond prices and bond yields move in opposite directions. When yields go down, prices go up and investors can still realize a positive return when they sell the bonds at a later date. Hedged international bonds have consistently outperformed their U.S. counterparts nearly every year since 2014. While past performance is no guarantee of future performance, this illustrates that ignoring an entire asset class because of a low or negative yield will cause you to miss out on other benefits, such as price appreciation and diversification.

Source: Morningstar Advisor, 10/15/2020

Diversification is (nearly) everything. Don’t let the headlines distract you from that.

Asset allocation accounts for 91.1% of a portfolio’s movement over time (8.9% is security selection and market timing). Bonds serve a role, negative interest rates or not, in a long-term portfolio. They are a stabilizer and a diversifier to balance out stocks, which are volatile and risky. Vanguard continues to use an international bond index to account for 30% of the total bond portion of their target date funds because of their research showing that it increases diversification and decreases volatility in the portfolio.

Investors who are retired, in particular, tend to focus on the income or yield that a portfolio generates. It is appealing to think that they can just live off the income that their portfolio generates so they can leave the principal untouched. The problem with this approach is that when the portfolio does not produce enough income, as in most cases, they begin reaching for higher income-producing investments. That leaves them with a portfolio that is more concentrated and risky. Instead of focusing on income, focus on the total return potential of your portfolio. You will end up with a better balanced, more diversified portfolio over the long run.

Linda Rogers, CFP®, EA, MSBA is the owner and founder of Planning Within Reach, LLC (PWR). Originally from New Jersey, Linda services clients nationwide and is based in San Diego. She leads the design of PWR's investment portfolios which utilize broad, low-cost investments that integrate environmentally, socially, and governance (ESG) factors.

Planning Within Reach, LLC (PWR) is a virtual fee-only and fiduciary wealth management firm offering one-time comprehensive financial planning, ongoing impact-focused investment management and tax preparation services. PWR is a woman-owned firm that specializes in busy professionals and impact investors. Planning Within Reach, LLC and their advisors do not receive commissions and do not hold any insurance licenses or brokerage relationships.