When yields go negative, what's an investor to do?

With interest rates at astonishingly low levels—even to the point of some instruments offering negative yields—what’s an investor to do? Some may decide that the answer is to take more risk and look for more return from other sources. But it may make more sense for some investors to look to reduce the amount of risk that they are taking. Here’s why.

Even more topsy-turvy than before

Let’s start with the negative yields. And this is not just negative after-inflation yields (the five-year real Treasury yield dropped below zero as long ago as 2011—subsequently popping back up above—and so far this year has fluctuated between -0.32% and +0.34%¹). I mean negative nominal yields: investments that are certain to give you less back than you put in. That’s a difficult situation to rationalize.

The return on low-risk investments has been falling, in the U.S. and in many other places, for many years. Short-term debt issued by the stronger members of the euro zone—Germany; Finland; the Netherlands—has been trading at negative yields for much of 2015 so far. Even some corporate debt (such as Nestlé’s²) has dipped into negative territory. And the Swiss government last week issued ten-year debt at a negative yield. You earn nothing if you lock your cash in a safe-deposit box, but even nothing is better than what you will earn from a debt instrument that offers a negative yield. These are strange times.

Do you try to make up the difference somewhere else?

For an investor with a fixed target level of return—let’s pick 6% for the sake of argument—the steady drop in yields over the past 35 years creates a problem: if a lower return is available from low-risk investments, then that the difference needs to be made up somewhere else.

Other sources of return that may be targeted include things like the equity risk premium (the reward you expect for holding equities, instead of the much safer Treasury security); or the credit premium (the reward for holding debt that is less secure than Treasury debt); or it could be the illiquidity premium; or the term premium; or the active management return. And so on. All of these other sources of return tend to involve risk of some sort.³

Simplifying a little, the logic might run as follows: “when I earned 3% simply for supplying money to the capital markets, I needed an extra 3% from my various risk exposures. Now that I’m earning nothing for supplying capital, that 3% has turned into 6%.”

So some investors may respond to the decline in interest rates by increasing risk in their portfolios.

Or do you lower your return expectation instead?

But increasing risk doesn’t make sense for everyone.

Risk does not become less risky just because yields have fallen. So a different investor might follow a different chain of logic: “My risk tolerance is based on a trade-off between risk and reward. My decision on how much risk to take is based on the reward that is available for taking risk (the risk premium), not on the reward that is available for not taking risk (the risk-free return.) I struck a good balance when I targeted an extra 3% of return. I’m not throwing that out of the window just because interest rates have fallen.”

Such an investor may simply lower their return expectation and keep on with their same strategy.

And there’s a third possible response. Here, the investor may reason as follows: “the risk-free return is lower, so there is more money chasing other sources of return. That, in turn, means that the reward-per-unit of-risk-taken has likely been pushed down. This is not the smart time to take risk. I’m taking less of it. I’ll take more when I like the odds better.”

So this investor would step back for the time being, and dial back the risk in their portfolio.

There’s more than one way to respond

That makes three possible responses to the low-yield environment. Low (and negative) yields mean investment is tougher. How you should respond depends on what you are trying to achieve: do you really need to target a particular expected return no matter what? Or can you afford to reduce your targeted return, with a view to increasing it again at a later date when conditions are more favorable?

There’s more than one rational way for an investor to respond to this strange world of negative yields.

¹ Source: U.S. Treasury.

² Any stock commentary is for illustrative purposes only and is not a recommendation to purchase or sell any security.

³ If there are ways to make the assets work harder that don’t involve risk, then that’s worth doing whatever the level of interest rates. So we’ll ignore that option here.