Markets & Economy

Interest rates are fundamental to investing. The income you earn in a savings account, the interest you pay on your mortgage, and the yield you earn on a bond are all determined by underlying interest rates in the economy.

Over the past six months, those rates have fallen significantly, impacting borrowers and savers alike. In the below, our Managing Director for Fixed Income at Manning & Napier, Marc Bushallow, shares his thoughts on falling interest rates and what it means for the average investor.

Interest Rates Are Falling Again

One of the most fundamental interest rates in the economy is the policy rate set by the Federal Reserve (Fed). As the economy gradually recovered from the financial crisis, the Fed began raising this interest rate to what they considered to be a more normal level. Their goal was to prevent the economy from overheating, as well as to stave off any potential uptick in inflation.

After raising rates over the course of several years, the Fed has changed course. A weaker than expected global economy and limited inflation pressures—as well as a sharp jump in stock market volatility—caught Fed policymakers off guard. They have since shifted gears and are attempting to undo some of what they’ve done by bringing rates back down.

The Impact of Low Rates

Lower interest rates impact borrowers, savers, and investors in three main ways. First, lower interest rates help borrowers. They make it cheaper to take out a loan, whether that is a mortgage to buy a house, a loan to buy a car, or a line of credit to buy equipment for a business. A lower interest rate encourages borrowers to draw on their credit, in turn, stimulating the economy.

Second, lower interest rates challenge savers. Those who are in retirement, or have otherwise already accumulated a large sum of wealth, stand to face certain adverse consequences from falling interest rates. Many savers are looking to generate yield from their savings, and declining interest rates lessens that rate of yield, ultimately reducing income.

Finally, investors sometimes view lower interest rates as a bad sign for the economy. Interest rates and economic growth are closely related, so higher levels of economic growth and higher interest rates often go hand-in-hand. Conversely, if interest rates are falling, investors may interpret that as a sign that economic growth is also slowing, potentially sparking market volatility.

Understanding Negative Interest Rates

Negative interest rates have become normal in the post-financial crisis world. Approximately 25% of government debt, or over $15 trillion worth, now has a negative yield. So, while many believe interest rates can’t go lower than zero, the reality is that they can, and already have in Japan and many countries in Europe.

Source: Bloomberg (08/23/19).

Investors looking to generate income through negative yielding government bonds may be shocked when they realize what a negative rate means: investors lend money and get less in return. The implications of this upside-down world are staggering. For example, some homeowners in Denmark hold mortgages that pay them, as in principal minus interest as opposed to principal plus interest (1). Negative rates are strange indeed.

While negative yields generate many headlines, they aren’t telling the whole story. Interest rates are exceptionally low across all of fixed income, not just in government bonds, and they have been for most of the post-financial crisis period. Whether more of the bond market will soon experience negative interest rates, or simply lower rates, will depend on a few factors.

Factors Driving Bond Yields

Two of the most significant factors impacting the level of interest rates are market forces and central banks. The way those two forces impact specific bond yields depends on the type of security.

For example, longer maturity bonds, such as the 30-Year US Treasury bond, have a yield that is heavily influenced by market forces. Fixed income investors consider economic growth, inflation, and other macroeconomic factors when determining whether it makes sense to ‘lock-in’ a yield for a longer period of time. Weakness in US growth during the first half of 2019, as well as ongoing geopolitical uncertainty, have played key roles in driving long-term interest rates lower.

On the other hand, shorter maturity bonds are more heavily impacted by central banks. In July, for the first time since the financial crisis, the Fed reduced its policy interest rate, resulting in a sharp drop in short-term rates. As a result of both central bank policy and market forces, interest rates have fallen, creating a challenging environment for fixed income investors.

What Investors Can Do

Even though much of fixed income is not as attractive as it once was decades ago, it is still an important part of most investors’ portfolios, especially for those who are more conservative or closer to retirement.

There remain a number of avenues investors can explore to look for yield. Corporate debt (e.g., investment grade and high yield), as well as securitized credit (e.g., mortgages, auto loans, etc.), can provide a meaningful yield uptick. In each area, however, investors should be sure to employ a selective approach.

Fixed income investors are living in remarkable times, but that doesn’t mean that there is a void of opportunity. We encourage those seeking yield to consider an actively managed investment approach to most appropriately maximize income while managing risk.