During Janet Yellen’s recent Congressional testimony, she once again indicated she’s looking carefully at the possibility of a negative federal funds rate.
This is important to income investors and retirees who must protect themselves from this very real possibility. It requires an understanding that should rates go negative, investors must find safe alternatives, while avoiding riskier asset classes.
So let’s start with one truly terrible investment group – banks.
That’s right. Banks do very badly in the presence of negative interest rate policy (NIRP) because they remain unable to pass the negative interest rates on to their depositors. Should they even attempt to do so, customer deposits would vanish into mattresses across the U.S.
Unfortunately, this means that their profits will be squeezed to the point of invisibility. The result is that the cost of their funding will exceed what they receive on risk-free assets – making banks very bad investments.
And that’s just one of many reasons why negative interest rates are a dangerous idea.
Such rates would also cause banks to reduce their leverage and cut back on their lending, because the spreads between deposit and lending rates would no longer be sufficient to cover their expenses. Bank layoffs are already ratcheting upwards.
Ironically, by pushing interest rates negative, central banks actually achieve the opposite of their stated goals.
Of course, the world’s central banks, along with various Keynesian hacks, are pushing the idea of getting rid of cash altogether. The thought here is that by banning cash, depositors would be unable to keep their cash out of the hands of banks. In addition, this gives central banks the ability to set rates at any level they deem necessary.
For retirees and other income investors looking to supplement their income, negative rates have devastated older savers. Japan illustrates the idiocy of going negative on rates.
Japan has suffered with zero interest rates longer than any other country and recently went to a negative rate. How has it worked out?
Fourth-quarter GDP was down at 1.7% (annual rate) and January exports were down 12.9% from a year earlier. Clearly, negative rates have failed miserably at spurring economic growth.
What’s more, Japan Post Bank shares are down 18% from their price in November because Japan’s negative interest rates hamper the bank’s business model (its assets are almost all low-risk Japan Government Bonds, which now yield zero for a 10-year maturity).
Now we’re witnessing Japanese investors becoming increasingly annoyed at their government that lured them into supposedly safe investments, while simultaneously decimating valuations with monetary policies that destroy wealth.
But that doesn’t mean there’s no hope for income investors…
Negative short-term interest rates will produce a few winners, such as large dividend stocks and a group of stocks that pays spectacular dividends: residential mortgage real estate investment trusts (REITs).
Residential mortgage REITs fund themselves in the short-term markets and invest in home mortgages guaranteed by Fannie Mae and Freddie Mac. By using leverage, they’re able to turn the 3-4% yields on mortgage bonds into 10-20% returns, most of which are paid out as dividends.
Now, I’ve been fairly pessimistic on the mortgage REIT sector. They remain relatively high-risk investments when interest rates are rising. You see, if interest rates go up, the “gap” between short-term funding costs and long-term bond income disappears, and the value of the REIT’s bond portfolio declines.
This is exactly what happened in 2012-13, when American Capital Agency Corp. (NASDAQ: AGNC) shares lost half of their value in six months.
But with negative interest rates, the opposite happens. The cost of funding, being based in short-term money markets, declines – probably below zero (the REITs can borrow cheaply because they can “repo” their low-risk bond portfolio).
At the same time, the yield on assets stays well above zero. And if mortgage rates, in fact, decline, the value of the portfolio increases, giving the REIT a capital gain. Thus, either net income increases or capital appreciates – a win/win.
The two largest pure home mortgage REITs are AGNC and Annaly Capital Management Inc. (NYSE: NLY).
AGNC, with a market capitalization of $6.1 billion, is trading at 79% of book value and offering a dividend yield of 13.7% based on quarterly dividends of $0.60 per share.
NLY, which has a market capitalization of $9.4 billion and is trading at 83% of book value, offers a dividend yield of 12.3% based on a quarterly dividend of $0.30 per share.
Neither of these companies earns enough to cover their dividends, based on trailing four quarters earnings, because short-term rates have been trending upwards, narrowing spreads and pressuring capital value.
But if Yellen does decide to lower rates below zero, both companies are poised to benefit spectacularly, probably giving you a capital gain as they come to sell above book value.
Still, don’t put too much in them – they remain above average risks.