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What happens if interest rates fall below zero?

25 June 2020

5 minute read

As the UK government issues bonds with a negative interest rate for the first time in recent history, we explore why this has happened and ask why anyone would want to pay for the privilege of lending money.

Who's it for? All investors

The value of investments can fall as well as rise. You may get back less than you invest.

What you’ll learn:

  • Do negative interest rates work?
  • Who would buy a bond paying a negative interest rate?
  • What does this all mean for me?

Certainly for the first time in recent history, the UK government has been able to raise new money by issuing bonds with a negative interest rate. What this means for an investor buying these bonds is that, should the bonds be held to their maturity date, the investor will get back less than they lent. But, does this seem like a sound investment?

Why has this happened?

On the one hand, some investors are anticipating a new bout of bond buying by the Bank of England to stimulate the economy, which would push bond prices higher and yields – the return you receive for holding the bond – even lower. Bond prices and yields are inversely correlated. This means that as prices rise, yields fall and vice versa. On the other hand, investors may just be buying these bonds to protect against deflation – or falling consumer prices. This is because, in a deflationary environment, interest rates are reduced to stimulate the economy which causes bond prices to rise. Investors could then sell these bonds for a profit before they mature.

It is worth pointing out however, that while negative yields mean certain losses if the bonds are held to maturity, they could produce profits for nimble investors if the bonds temporarily rise even further in price and the investor sells before the bonds mature.

Do negative rates work?

The coronavirus pandemic has caused a global slump in economic activity as lockdown restrictions have forced many businesses to shut and has caused high levels of unemployment around the world. To help support the global economy in these challenging times, central banks have cut rates to make borrowing money as cheap as possible. The purpose of this to encourage people and businesses to borrow, invest, and spend, which should help to stimulate economic activity.

Negative interest rates have been used in Europe, Japan and elsewhere so it is possible that they may happen in the UK – the Bank of England base rate is currently just 0.1%. However, the evidence of the success in Europe and Japan is mixed. The lacklustre growth and inflation both places have experienced in recent years is often offered as proof they haven’t worked, but others argue this ignores the possibility that growth and inflation could have been even lower without negative rates.

Market participants believe that the chances of the Federal Reserve (Fed), the US central bank, cutting policy rates into negative territory is very unlikely, though the Fed hasn't explicitly ruled this out. For the Bank of England, investors have been receiving more mixed messages from the governor, Andrew Bailey. Mr Bailey had initially announced that the Bank of England would not consider negative policy rates whereas now he has said that the Bank is assessing the possibility. 

Who would the buyers be?

While lending money with the distinct possibility of receiving less back may not appeal to everyone, there are some for whom this still offers a viable option. Institutional investors are sometimes obliged to invest at least a proportion of their assets in less risky assets such as developed government bonds.

But it’s not just institutional investors who may buy these bonds. A combination of benign inflation expectations and low expectations for growth may make some investors willing to accept a negative return on their investment. This is because the investment will still retain most, albeit not all, of its value over the term of the bond. Also, if the outlook deteriorates, an investor will get a higher return on bonds (as interest rates decline) than on cash.

What does this all mean for me?

In terms of savings, it’s not good news. Returns on cash accounts have been very low for a long time and most do not even beat inflation. Negative interest rates may ultimately mean that leaving money in cash at the bank will actually lose value over time although this is not yet the case.

For anyone with a mortgage, negative rates could lower the rates on new mortgage deals. However, most home loans include clauses to prevent the interest turning negative. Last year, a Danish bank launched the world’s first negative interest rate mortgage – handing out loans to homeowners where the charge was minus 0.5% a year. However, in reality, the mortgage borrower in Denmark is likely to end up paying back a little more than they borrowed, as there are still fees and charges to pay to compensate the bank for arranging the deal, even when the rate is negative.

As an investor, a negative interest rate would mean that risk-free assets, such as cash deposits and government bonds, would deliver lower returns. If an investor is seeking a higher return, they would most likely have to invest in risky assets, such as shares, to hope to achieve a higher return though these, of course, can lose value and deliver negative returns.

Where to invest

How you might invest in a negative interest rate environment depends entirely on your investment goals, time horizon and attitude to risk. However, we would always recommend a long-term diversified approach to investing. The Barclays Ready-made Investments are just one example of a range of diversified funds which allow you to select the level of risk you are most comfortable with. These multi-asset funds invest across a range of asset classes and regions, offering a globally diversified one-stop solution for investors. Ready-made Investments are not the only funds that we offer and they won’t be appropriate for everyone.

Smart Investor offers a wide range of funds, and our Barclays Funds List may help you to narrow down the wide range available to invest in. These funds are selected by Barclays investment specialists and, based on our research, they’re the funds that have built solid reputations and established sound investment processes.

Funds are designed for the long term so you should only consider them if you can stay invested for at least five years.

These are our current opinions but the future, as ever, is uncertain and outcomes may differ.

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The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances. Smart Investor doesn’t offer personal financial advice. If you’re not sure about investing, seek independent advice.

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