In India, given the growth and inflation, the rate of interest won’t turn negative, at least any time soon.
Two interesting events in the last few weeks have taken economies around the world by surprise. First, markets across the globe have been roiled over the past few weeks after ‘the yield curve’ of bonds became inverted. Next, there has been this news of a bank in Denmark offering a home loan with negative interest rates.
Perplexed on what these terminologies and offers mean? Here is a low down on all these terms and also a take on what this means to Indian borrowers and investors, if at all.
What are yields? And what is a yield Curve?
Bonds or debt instruments that are listed on the exchanges get traded by buyers and sellers. At any point in time, a bond would carry a yield or a likely rate of interest or return that an investor is likely to generate if the bond is held till maturity. The yield keeps changing based on the prevalent interest rate scenario, prospects for economic growth, tenure of the debt, credit ratings and inflation.
A yield curve is a plot or graphical representation of the yields of bonds maturing across maturities – say from three months to 30 years. All listed bonds issued by governments, corporates and financial institutions carry certain yields.
Usually, bonds with a longer tenure carry higher interest rates compared to ones that are issued for shorter timeframes. The idea is that the later redemption or gratification, the higher should be the interest offered.
For example, if an issuer of bonds raises funds for one year he would offer an interest of 7 per cent on an AAA-rated paper. But if same issuer raises sums for a three-year period, he is likely to offer 7.75 per cent interest. The additional 0.75 percentage point is the extra compensation the bond buyer receives.
That is why, when a yield curve is drawn, it typically points upward. However, this conventional logic has gone for a toss in some countries.
What is an inverted yield curve and why is it relevant?
In many western countries and even some Asian majors, the yields on long-term bonds are lower than those for shorter tenure debt instruments. Therefore, the yields curve now would be ‘inverted’.
For example, a three months security carries a higher interest rate than that of the two-year bond. The three-month German bond yield stands at -0.713 per cent, whereas the two-year security’s yield stands at -0.89 per cent. In Japan, the three-month bond yield is -0.13 per cent, while that for the two-year debt instrument is -0.287 per cent.
On August 14, in the US, the two-year bond yield (1.5588 per cent) was higher than that for the 10-year security (1.5539 per cent) for a brief while.
“An inverted yield curve has historically been a precursor to a recession in the US. So, the markets are betting that the US economy will enter into a recession in the next few quarters. But it is by no means a given that a recession has to follow an inverted yield curve,” says Ashutosh Datar, a Mumbai based independent economist.
“We have to look at the possibility of a recession or a massive slow-down in the global economy in the backdrop of unprecedented technological disruptions worldwide, global trade wars, shift away from fossil fuels, near zero interest rates limiting the central bankers’ ability to revive economies and geo-political instability in all parts of the world,” says an actuary employed with a leading pension consultancy firm, who wish not to be identified.
Why negative yields and interest rates?
Investors are willing to buy bonds at any price to protect themselves against sell offs in other risky assets in case the fear of a recession materialises. The rise in bond prices pushes yields downward. Holding cash can be an alternative. But that too may not work in the case of many western countries. For example the largest wealth manager in the world, UBS, announced a charge of 0.75 per cent payable by customers with cash savings of more than two million Swiss Francs.
Investors can also choose to invest in bonds issued by a government or an entity in a particular currency which is expected to remain stable and retain its purchasing power over a period of time. Hence in some cases they are willing to settle for negative returns on bonds.
“Negative yields are bad for savers. It leads to mis-allocation of capital. It leads to mis-pricing of risk premium and leads to investments in risky or over-valued assets,” says Devendra Nevgi, founder and principal partner of Mumbai based Delta Global Partners, an asset class research provider.
Should investors in India be worried about all this?
In India, the macroeconomic scenario is quite different from that of developed nations. India has both inflation and economic growth. “With inflation and wage growth in developed countries remaining subdued, nominal interest rates are likely to remain well below historical averages for the foreseeable future. But given that inflation in India is still around 3-4%, interest rates are unlikely to fall as low as those in developed countries,” says Datar.
As mentioned earlier, the saver is compensated for delayed gratification. An investor has to be paid an interest that protects his purchasing power after accounting for inflation. Hence the nominal rate of interest payable on bonds needs to be higher than the prevailing inflation. Hence, in India, given the growth and inflation, the rate of interest won’t turn negative, at least any time soon.
“If the inflation turns negative, then there is a possibility of negative rate of interest. In India, it may not happen,” says Devendra Nevgi, He says Indian growth may slow down but we may not see recession and in such circumstances we will have positive inflation. The nominal rate of interest below inflation numbers will be a bigger problem for a country such as India where savers have limited investment options.
For the time being, Indians should be focusing on the rate of interest they receive and pay. It may be too early to expect a financial institution to pay you for taking a loan.
