Slow economic growth has prompted central banks in some parts of the world to try a new monetary policy—negative interest rates. Several countries, including Japan, Switzerland, and Denmark, have turned the financial status quo upside down, essentially charging savers and paying borrowers. By penalizing idle savings and subsidizing the use of credit, central banks hope to stimulate spending and kick start their economies.
The negative yields on bonds in these countries, however, have not meant losses for U.S. investors who hold such bonds in globally-diversified portfolios. Investors who hedge currency exposure (as Vista does) enjoy not only reduced volatility, but also neutralized effects from negative, foreign bond yields. The main reason for this is interest rate parity.
Interest rate parity is a term which describes the relationship between two countries’ interest rates after accounting for their currency exchange rates. Any interest rate advantage one country has relative to another is offset by its currency exchange rate. If this were not the case, it would be possible to borrow in a country with low (or negative) interest rates and lend those proceeds in a country with high rates, securing a riskless profit in the process. But, as the old saying goes, there is no such thing as a free lunch in investment markets.
Fierce competition in bond and currency markets effectively maintains the equilibrium between interest and exchange rates. Imbalances are rare and the small discrepancies which do occur are quickly eliminated as opportunistic traders rush to exploit them.
Because of interest rate parity, buying a bond in a foreign market with higher interest rates does not increase an investor’s yield. Conversely, investing in a foreign market with lower (even negative) rates does not decrease an investor’s yield. The effect of currency exchange essentially translates the foreign bond’s yield to the investor’s home-country interest rate level. Buying contracts which lock in future exchange rates (hedging) shelters foreign bond holdings from the effects—positive or negative—of subsequent currency movements.
If currency exchange rates effectively equalize foreign and home-country bond yields, what is the appeal of investing abroad? Diversification. Spreading a portfolio’s bond holdings across a larger number of high-quality issues reduces risk.
It is also important to remember there are two components to bond returns: yield and price change. Bond prices move in response to changes in interest rates. Prices fall when rates rise and rise when rates fall. Since interest rates across countries don’t necessarily change at the same time or move in the same direction, global bond portfolios experience less fluctuation over time compared to single-country portfolios.
Whether negative interest rates will have the desired effect of spurring economic growth remains to be seen. Central bankers everywhere are watching closely to evaluate the effectiveness of these experimental measures. In the meantime, however, bond investors should not be deterred from seeking the benefits of global diversification.
Editor’s Note: This article was originally penned by our late colleague, Gordie Gorsuch, whose timeless wisdom lives on in Vista’s investment philosophy.