Fixed Income—In Depth

Topics in this report:

• Key Insights
• Why do investors buy negative yielding debt?
• Lessons learned from negative yields overseas
• Could we see negative interest rates in the United States?
• Portfolio management in the face of negative interest rates
• Consider alternative investment strategies

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• Currently, we can observe two types of negative interest rates in developed markets: negative policy rates driven by central banks and the negative yield to maturity of several bonds.¹
• Negative yielding debt now comprises more than 20% of the Bloomberg Barclays Global Aggregate Index.² While negative yields have been seen in many developed markets overseas, investors have wondered whether the U.S. could face negative domestic fixed-income rates ahead.
• Negative interest rates have had a major impact on the banking sector in Europe and Japan, and bank investors also are focused on this question.
• We do not believe that negative interest rates are a near-term risk for U.S. fixed-income markets. We do believe that investors should consider different global investment strategies in today’s negative- and low-yield environment. We outline these strategies in this report.

Global economic growth and inflation at the lowest levels in generations have been a reality since the 2008 financial crisis. As a result, interest rates have reached negative levels in several developed markets as policy makers have sought to spark economic activity. Concerns about negative rates recently have increased—as the amount of negative yielding debt has risen to more than 20% of the Bloomberg Barclays Global Aggregate Index. Many developed market sovereign and corporate bonds overseas now offer a negative yield to maturity (but not necessarily a negative coupon).³

The amount of global negative yielding debt has been building since 2014 (Chart 1). Two periods of sharp increases came in 2015 and mid-2019, corresponding to times when concerns rose over a relapse into global economic recession. This year’s gain was especially strong as negative yielding debt rose from $10 trillion in March to nearly $17 trillion in August (although it had fallen to a level that was close to $13 trillion by late October).⁴

Chart 1. Negative yielding debt globally rose to nearly $17 trillion in August 2019Sources: Bloomberg, Wells Fargo Investment Institute. Monthly data from January 31, 2010 – December 31, 2016. Daily data from January 10, 2017 to October 21, 2019. The Bloomberg Barclays Global Aggregate Negative Yielding Debt Index is a sub-index of the Bloomberg Barclays Global Aggregate Index that measures the amount of debt that has a negative yield.

Between 2014 and 2016, negative yields became common overseas when central banks responded to weakening economic activity by lowering short-term interest rates (Chart 2) and increasing bond purchases. As the need for stimulus grew, central-bank policy makers in some countries lowered policy rates below zero and bought additional securities, mostly from commercial banks, with the goal of providing banks with more funds to lend.

This year’s surge in negative yielding debt followed a global weakening in manufacturing activity that was aggravated by the difficulty of predicting an outcome to the U.S.-China trade dispute. Since 2016, many major central banks have continued to reduce rates—but they also have shifted their primary policy emphasis away from short-term rates toward new bond-buying programs. As a result, countries that were seeking to stimulate their economies drove interest rates below zero at longer maturities. Close to 70% of the dollar value of negative-yielding debt is concentrated in government bonds from Japan, France, and Germany, but there are also corporate issues (non-U.S. dollar bonds) currently trading at a negative yield to maturity.⁵ The European Central Bank (ECB) has been buying debt since 2016, and approximately 45% of the negative yielding debt is from European issuers.⁶

There are several reasons why investors have purchased negative yielding debt. These include:

1. Central banks have remained significant purchasers of negative yielding debt as part of their quantitative easing monetary programs.
2. Some investors have bought negative yielding issues for “perceived safe haven purposes.”.
3. Many institutional investors have been forced to buy these securities despite the negative yields—because their investment policy statements prescribe the holding of certain bonds—such as sovereign debt and high-quality corporate issues.
4. Still other investors have bought negative yielding debt for total return, under the assumption that central banks and other investors will buy these bonds at even lower yields in the future (resulting in potential capital gains by driving the same bonds’ prices ever higher).

Chart 2. Developed market central banks have driven policy rates into negative territorySources: Bloomberg and Wells Fargo Investment Institute as of October 15, 2019. Daily data: January 2, 2010 – October 15, 2019. Central banks whose rates are included in this chart are the Danish National Bank (DNB), European Central Bank (ECB), Swiss National Bank (SNB), Swedish Riksbank (SR), and the Bank of Japan (BoJ).

By reducing interest rates to levels that are below zero, policy makers try to make spending and investing more attractive than holding low risk investments such as bank deposits. But unintended consequences can accompany any policy. For example, one risk to a negative-rate policy strategy is that households and businesses may instead increase their savings rates to compensate for the loss of interest income. We believe many of these policy implications offer lessons for the United States. These include the following:

• Negative rates have not incentivized higher spending growth: Households in developed markets overseas recently have shown a preference for holding more cash; they have increased the size of their savings. Meanwhile, demand has increased for large-denomination currency bills and safe-deposit boxes in Japan and Switzerland. Likewise, many businesses are not spending to expand their productive capacity⁷; instead, they are widely issuing bonds to finance equity share buybacks. Negative rates appear to have impaired confidence and increased household savings levels in developed markets overseas.
• Negative rates have hurt the banking system in developed market countries—which is a primary mechanism to transmit money into economic growth: The nation’s money supply rises or falls as banks lend more or less actively. But banks in developed markets have been reluctant to “charge” private individuals or businesses for deposits, even as these banks have paid to hold their cash assets as reserves at the central bank. Further, borrower caution has held down loan demand enough to prevent banks from offsetting the higher cost of holding reserves at the central bank. Consequently, bank profitability has suffered. The slowing economy and dark clouds over global manufacturing and trade have added to European bank equity underperformance since mid-2018 (Chart 3).
• Defined-benefit pension plans and insurance companies could be at risk over time: As developed market central banks buy more and more of the available high-quality bonds, bond yields have turned increasingly negative. Consequently, it is difficult for pension plans and insurance companies to match the income earned by their assets with the payouts required to meet their liabilities over time. Negative interest rates also can cause pension plans to be underfunded at higher overall levels—forcing larger amounts of cash injections by employers into plans.

Chart 3. Recent underperformance of European bank equities tracks increasingly negative ECB ratesSources: Bloomberg and Wells Fargo Investment Institute. Daily data, January 1, 2013 – October 18, 2019. ECB = European Central Bank. The deposit rate is one of three policy target rates set by the ECB. Bank relative performance is shown as the ratio of the Euro Stoxx 600 Bank Index to the Euro Stoxx 600 Index, both in euros, and indexed to 100=January 1, 2013.

Negative interest rates in Europe and Japan could lead some to conclude that negative interest rates may come to the U.S. in the future.⁸ There are some similarities between these developed market economies, in that U.S. growth and inflation have been below their historical averages over recent decades. Further, the Federal Reserve (Fed) has sought to stimulate the U.S. economy with low interest rates and bond purchases. Yet, we believe that negative interest rates have a low probability of occurring in the U.S. There are several reasons for this view.

1. The U.S. has not shown a tendency toward deflation: Deflation is a decline in prices, and it is part of the backdrop that has led to negative interest rates in Japan and Europe. When economies struggle to generate positive returns (such as has been the case in some developed markets abroad), inflation trends lower and deflation risks accompany recessions. For decades, Japan’s economy has fluctuated in a narrow range between weak expansion and slight contraction, and the country’s price level has mirrored its economy. Europe is not much better. U.S. economic growth is stronger than in these locales, and U.S. prices show no sign of turning negative—even though U.S. inflation has cooled from historical levels. U.S. core consumer price inflation (i.e., excluding the volatile food and energy components) has remained above 2% for most of this economic expansion; it was above 3% for most of the summer of 2019. Positive U.S. growth and inflation help protect against the development of negative rates.
2. The U.S. dollar’s dominance helps to fend off negative interest rates in the U.S.: The dollar is the world’s main reserve currency, which means that the U.S. can print more dollars to help generate more loanable funds at U.S. banks. This is a crucial advantage. Countries like Italy cannot print more euros; instead, they must rely on the ECB to reduce rates and to buy government bonds to fund their government expenditures. During the euro crisis of 2010-2011, Italy’s 10-year government bond yield was close to 8%. Yet, it was 0.9% in late October, thanks—in large measure—to ECB policies.⁹ Japan (and potentially other Asian countries), along with Scandinavian countries, may also choose negative yields to push down the value of their exports, in order to generate more liquidity.

   From the Fed’s perspective, negative interest rates actually might do considerable damage to the dollar as the world’s main reserve currency, by causing other governments and international investors to hold their reserves in gold or in other currencies. Remarks from Fed Chair Powell (and other Federal Open Market Committee members) at the Jackson Hole Symposium and at several other engagements afterward have indicated that the Fed wants to avoid negative interest rates.¹⁰

3. The Fed does not clearly have statutory authority to set negative interest rates: It is not clear that the Fed currently has the legal authority to impose negative interest rates on bank reserves. This legal constraint would have to be addressed. To this point, Fed Chairman Powell has expressed reluctance to use negative policy interest rates in the U.S. (as there isn’t compelling evidence from the experience overseas that the desired results have been achieved).¹¹ Fed policy makers have emphasized that other tools such as policy guidance and quantitative easing are more suitable for the U.S., given its market structure.¹²
4. Negative rates have not spread across the U.S. economy in the past: Chart 4 shows several prior occurrences of negative U.S. Treasury bill rates, when the U.S. economic recovery did not turn to recession. Although this could happen again if the Fed policy rate were to approach the zero bound, we don’t expect negative interest rates to extend to longer-maturity U.S. Treasury notes and bonds in this case. The market for U.S. government bonds is much larger than those of other countries (Table 1) and this ample supply, coupled with consistent government debt issuance, will make it difficult to push yields into negative territory

Table 1. Size of government bond markets in select countriesSources: Bloomberg and Wells Fargo Investment Institute. Daily data, January 1, 2010 – April 30, 2016

Chart 4. U.S. Treasury bills have seen negative yields beforeSources: Bloomberg and Wells Fargo Investment Institute. Daily data, January 1, 2010 – April 30, 2016

In the event of negative interest rates, we see three primary ways that an investor could lose money:

1. Loss of principal if a government debt (or other) security was held over time to maturity.¹³
2. The loss of purchasing power, because inflation is positive, but yields are negative.
3. The opportunity cost relative to other investment returns that are above zero.

Just because a bond may have a negative yield, it does not necessarily mean that it will result in a negative return if it is sold before maturity. Should negative rates unexpectedly become widespread domestically, investors may want to consider managing their bond holdings—and their equity holdings—a bit differently than they have in the past.

Below, we outline investment strategies that investors can consider in a slow-growth environment with negative, and low, interest rates around the world.

Chart 5. European government bonds—Returns versus yieldsSources: FactSet and Wells Fargo Investment Institute as of October 17, 2019. Daily data, January 1, 2018– October 21, 2019. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Fixed income: Fixed-income securities traditionally have been held for their yield or income potential and to add stability to a portfolio over the longer term. In a negative-rate world, the income potential of fixed-income holdings may become challenged. Yet, bonds clearly can still play a role in portfolios.

1. Quality, investment-grade corporate bonds should continue to pay a premium (albeit a small one) over U.S. Treasury security yields. They also can add stability to a portfolio (particularly relative to higher-risk assets).
2. Investors can consider preferred securities, which may offer somewhat higher yields, longer duration, and characteristics that are more similar to equities.¹⁴ Diversified, professionally managed holdings are recommended in this space.
3. Investors may consider holding emerging market fixed-income investments, which can offer higher yields—but also increased volatility. Emerging market debt investments that are denominated in dollars may offer yields that are higher than those in the U.S., Europe, and Japan today.
4. Investors also can consider rebalancing fixed-income assets into equities at opportune times. Equities can, of course, offer both income and capital appreciation potential. In other words, when equity prices fall, investors might consider reducing portfolio exposure to fixed income to generate cash with which to put into comparatively cheaper equities.

Equity markets: We believe equities are likely to remain volatile in the coming quarters, and earnings growth may not support as much capital appreciation as in the past. However, equities may remain a better source of return than bonds in the coming quarters (particularly with negative rates in global markets). There are several reasons for this:

1. Equity cycles may be shorter and have less amplitude in an economy that is less prone to extremes of growth than it was in the past. Investors who are proactive may rebalance into equities at the lower end of the cycle and then rebalance again, putting cash back into bonds, when equities become expensive relative to our targets.
2. Dividends can become a principal source of income. Over decades, dividends have compounded at rates above consumer price inflation and just below equity price returns, but with a fraction of the volatility. Between 2007 and 2009, the S&P 500 Index fell by 21.4%, but dividends declined by a lesser 17.6%.¹⁵
3. Traditionally defensive sectors are likely to see greater investor demand, especially for their dividends. Sectors that could benefit include Utilities, Consumer Staples, and Real Estate (which includes real estate investment trusts, or REITs).

Alternative investments can offer potential opportunities to benefit as traditional asset classes are weakening.

1. Investors may benefit from strategies that seek to capitalize upon distressed credit and falling prices among cyclical equity sectors.
2. For qualified investors, there may be opportunities in Private Debt or Private Real Estate, which take a longer-term view of returns
3. In addition, considering securities based on their strength in Environmental, Social, and Governance (ESG, or socially responsible) selection factors may be a way to select higher-quality companies that may outperform in a general downturn.

Investing in a world of negative interest rates is a new challenge for many investors. We don’t believe that the U.S. is likely to face negative interest rates in the near future, but we do favor weighing risk and reward, irrespective of the environment. In the coming quarters, investors may want to reconsider where they look for price return and income, and where they may be willing to tolerate volatility for that total return

¹ Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures and all coupon payments are made as scheduled.

² Bloomberg Barclays Global Aggregate Index, October 22, 2019.

³ The coupon rate is the yield that a bond pays on its issue date.

⁴ Bloomberg Barclays Global Aggregate Negative Yielding Debt Index, which is a sub-index of the Bloomberg Barclays Global Aggregate Index, and which measures the amount of debt with a negative yield; as of October 22, 2019.

⁵ Bloomberg Barclays Global Aggregate Negative Yielding Debt Index as of October 21, 2019.

⁶ iBid.

⁷ A Federal Reserve study showed that a marginal drop in interest rates failed to induce finance officers to invest more or to add capital projects. For more details, please see, “Why Isn’t Investment More Sensitive to Interest Rates: Evidence from Surveys”; Steve A. Sharpe and Gustavo A. Suarez. Federal Reserve Board. August 2015.

⁸ The U.S. saw negative interest rates on Treasury bills for a brief period in the past, but it does not currently have negative interest rates.

⁹ Bloomberg, data retrieved on October 21, 2019.

¹⁰ Remarks from Fed Chair Jerome Powell at the Jackson Hole Symposium in August 2019 and following the meeting of the Federal Open Market Committee on September 19, 2019.

¹¹ iBid.

¹² For more information, please see the Investment Strategy report: "The Fed's Shrinking Toolbox", October 14, 2019.

¹³ While credit default also can cause loss of principal (or interest), this would not typically apply in the case of investment-grade U.S. Treasury securities.

¹⁴ Duration is a measure of interest-rate risk.

¹⁵ S&P Global, data accessed on October 17, 2019.

Investments in fixed-income securities are subject to interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity. Although Treasuries are considered free from credit risk they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets. Sovereign debt is generally a riskier investment when it comes from a developing country and tends to be a less risky investment when it comes from a developed country. The stability of the issuing government is an important factor to consider, when assessing the risk of investing in sovereign debt, and sovereign credit ratings help investors weigh this risk. Preferreds securities have special risks associated with investing. Preferred securities are subject to interest rate and credit risks. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer's capital structure, subjecting them to a greater risk of non-payment than more senior securities. In addition, the issue may be callable which may negatively impact the return of the security. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic condition.

Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. There is no guarantee dividend-paying stocks will return more than the overall market. Dividends are not guaranteed and are subject to change or elimination.

Sector investing can be more volatile than investments that are broadly diversified over numerous sectors of the economy and will increase a portfolio’s vulnerability to any single economic, political, or regulatory development affecting the sector. This can result in greater price volatility.

Consumer Staples industries can be significantly affected by competitive pricing particularly with respect to the growth of low-cost emerging market production, government regulation, the performance of the overall economy, interest rates, and consumer confidence.

Real estate investments have special risks, including possible illiquidity of the underlying properties, credit risk, interest rate fluctuations, and the impact of varied economic conditions.

Utilities are sensitive to changes in interest rates, and the securities within the sector can be volatile and may underperform in a slow economy.

Sustainable investing focuses on companies that demonstrate adherence to environmental, social and corporate governance principles, among other values. There is no assurance that social impact investing can be an effective strategy under all market conditions. Different investment styles tend to shift in and out of favor.

Alternative investments carry specific investor qualifications which can include high income and net-worth requirements as well as relatively high investment minimums. They are complex investment vehicles which generally have high costs and substantial risks. The high expenses often associated with these investments must be offset by trading profits and other income. They tend to be more volatile than other types of investments and present an increased risk of investment loss. There may also be a lack of transparency as to the underlying assets. Other risks may apply as well, depending on the specific investment product.

An index is unmanaged and not available for direct investment.

Bloomberg Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment grade fixed-rate debt markets.

JP Morgan GBI Austria (Euro, Unhedged) tracks government bonds from Austria in euros and unhedged.

JP Morgan GBI France (Euro, Unhedged) tracks government bonds from France in euros and unhedged.

JP Morgan GBI Germany (Euro, Unhedged) tracks government bonds from Germany in euros and unhedged.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

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