There has been a lot of buzz about negative interest rates lately, as the idea that you would have to pay governments to borrow your money seems to turn the very foundation of finance on its head. But that is exactly what is happening right now for trillions of dollars in the world’s bond markets. Government bonds in Japan and across Europe are currently offering investors negative interest rates, thereby guaranteeing investors a capital loss if held to maturity. Why would anyone buy an investment with such a poor outcome? What’s causing interest rates to fall below zero? Could interest rates in Canada also fall into negative territory?

To understand how negative interest rates work, it’s helpful to break nominal rates (the rates that people are normally referring to when they talk about interest rates) down into their two constituent parts: inflation expectations and real rates. Inflation expectations reflect the market’s view of future inflation, while real rates are what is left over for investors after inflation. Although inflation expectations have dropped to low levels in regions with negative nominal rates, the larger driver of negative nominal interest rates has been the collapse in real yields. Real yields have declined significantly as a result of several factors.

As they approach retirement, the aging populations of most industrialized countries have increased the demand for bonds, which has pushed down interest rates. Intervention by central banks has also driven down real rates through both overnight policy rates (short-term) and quantitative easing (longer-term), in some regions to below zero. Barriers to investing outside of home markets also landlocks investor capital, driving up demand for domestic securities.

Why would anyone invest in a security that, if held to maturity, is guaranteed to lose them money? Surely investors would be better off putting money under their mattresses than in negative-yielding assets. First, while this may be true for individual investors, large pension funds and corporations are not so flexible and cannot easily withdraw from markets and store large sums of cash. Second, even if interest rates are negative, an investor might still earn a positive return on a negative-yielding bond if interest rates fall even further (and they sell before maturity). Third, defined benefit pension funds hold bonds to match their pension liabilities. Irrespective of the interest rate offered by the fixed income market, the investment is held as insurance against the impact of lower rates on pension liabilities, which increase as rates fall.

Many Canadian pension plans are likely asking, are negative rates possible in Canada? With the overnight rate well above negative territory, at 1.75 per cent, and the Bank of Canada governors currently signaling they’re unlikely to cut rates in the near future, we believe the likelihood of negative rates in Canada is low, but not impossible. Should the economy dip into a recession, it is entirely possible the BOC might cut the overnight rate to below zero to stimulate growth. In 2015, the BOC’s governor, Stephen Poloz, also mentioned the potential to use negative interest rates as an unconventional monetary policy tool, in times of financial stress.

More recently, there has been growing concern about the risk of economic distortions resulting from a prolonged period of negative interest rates. According to Sweden’s central bank, Riksbank, potential side effects of sustained negative interest rates include the creation of incentives for excessive risk taking, incorrect valuation of risk, the formation of asset bubbles and debt levels of corporations and households to increase “in an unsustainable manner.”

In fact, the Riksbank, raised its policy rate to zero in December 2019, partly due to concerns about possible harmful consequences of sustained periods of interest rates below zero. In contrast, just hours after the Riksbank’s interest rate move, the European Central Bank released a study defending the use of negative rates.

Although the evidence of the effectiveness of negative rates is inconclusive at this time, it is likely that the policy tool will be continued to be used for some time. While it’s improbable that we see negative rates in Canada in the near future, investors should consider that possibility over a longer time frame.

This piece was co-authored by Mike Wallberg, vice-president of marketing and communications at Leith Wheeler Investment Counsel.