Tuesday, May 22, 2012

The Problem With Low Interest Rates

I've had a column written by Gillian Tett of the Financial Times on my desk for almost two weeks.

Titled " Repression on Bond Sales Heralds an Era of Masochism", Ms. Tett discusses the apparent reality that government policies around the world are deliberately keeping interest rates on their debt artificially low in order to help reduce national deficits.

Just yesterday, for example, Germany sold 2 year notes with a 0% yield.  In other words, the German government will keep your money for two years and return it, with no interest.

True, investors don't have to buy bonds - the stock market is always available - but Ms. Tett points out that many institutions are required to buy bonds, regardless of the prevailing rate of interest.

Regulators in countries like Spain and Ireland are mandating that banks and pension funds to buy government bonds as a  means to financial stability, regardless of the rate of interest.  In addition,  central banks lead by our Federal Reserve are actively intervening in the credit markets to keep interest rates low.

Thus investors and savers are in effect are subsidizing debtors, helped by government policies.

But there's even a more insidious problem that low interest rates create.

If a pension fund has a large chunk of their assets invested in low yielding securities, returns are obviously negatively affected.

While it might seem like basic financial probity to have large investments in government and high quality corporate bonds, if these securities do not return the assumed actuarial rate eventually the funds will need to be bailed out - by the taxpayers, most likely.

Here's what Ms. Tett writes:

Consider what has happened with U.S. pension funds.  Five years ago, these typically had a 60 per cent equity allocation, with 30 per cent in bonds.  But last month, according to the Milliman survey, the top 100 funds placed 41 per cent of their $1,300bn worth of assets in fixed income - topping the equities ratio for the first time.  That shift might have looked rational a few years ago; after all, annualized returns for Treasuries in the past decade have been 6.8 per cent, versus 2.9 per cent for the S&P 500.

However, as I have written on numerous occasions on this blog, shifting to fixed income at the expense of equities makes little investment sense at a time when interest rates are at 60 year lows.

Ms. Tett continues:

But the timing {of the shift to bonds} looks terrible, given that, as David Goerz, chief investment officer of HighMark Capital says, "a 2 per cent Treasury yield is equivalent to a price/earnings ratio of 50x compared to a foward earnings multiple of 13x for the S&P 500 today".  Or to put it another way, it would make more sense, Goerz says, for funds to switch back into equities.


Low interest rates and pension fund allocations are hardly the stuff of front page news, but perhaps they should.