During recent Congressional testimony, Fed Chair Janet Yellen said she’s looking carefully at moving to a negative federal funds rate.
As income investors, we must protect ourselves from this very real possibility, while also recognizing that some investments are much safer than others.
So let’s start with one truly terrible investment group – banks.
Yes, banks will do very badly indeed under negative interest rates because they daren’t risk passing the negative interest rates on to their depositors. If they did, deposits would vanish into cash piles buried under mattresses.
So long as banks don’t pass negative rates on to their depositors, their profits will be badly squeezed. The cost of much of their funding will exceed what they receive on risk-free assets.
And that’s just one of many reasons why negative interest rates are a bad 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 overheads.
By pushing interest rates negative, central banks will achieve the precise opposite of their stated goals.
Of course, the world’s central banks, along with various Keynesian pundits, are pushing the idea of getting rid of cash altogether. That would allow central banks to set rates at negative 20%, or whatever crazy figure they feel like.
Thus, we have to hope that the combined power of “peasants with pitchforks” – even in the EU and Japan, where the people have a “sheeple” quality about them – will prevent central banks from implementing this very bad idea.
In Japan, which has suffered with zero interest rates longer than any other country and recently went to a negative rate, fourth-quarter GDP was down at a 1.7% annual rate and January exports were down 12.9% from a year earlier.
What’s more, Japan Post Bank shares are down 18% from their flotation price in November because Japan’s negative interest rates undermine the bank’s business model (its assets are almost all low-risk Japan Government Bonds, which now yield zero for a 10-year maturity).
Traditional Japanese retail investors are rightly annoyed at a government that lured them into a supposedly safe investment and then destroyed it with dozy policies.
A Silver Lining?
Fortunately, there’s also some good news for income investors.
Negative short-term interest rates will produce a few winners, including 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 leveraging, they aim to turn the 3-4% yields on mortgage bonds into 10-20% returns, most of which is paid out as dividends.
The $100 Trump Retirement Roadmap
Trump is set to unleash a $11.1 trillion tsunami in the markets…
Now that he's officially taken office, dozens of tiny firms could skyrocket by 100%, 300% and even 721%.
This is your chance to turn a small stake of $100… into a life-changing fortune.
Click here to find out how.
I’d always been down on the mortgage REIT sector, regarding it as very high risk. 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 happened in 2012-13, when American Capital Agency Corp. (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 do decline, the value of the portfolio increases, giving the REIT a capital gain. Thus, either net income increases or capital does, a double-sided gain.
The two largest pure home mortgage REITs are AGNC and Annaly Capital Management Inc. (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 high risk regardless.
For better sleep-at-night protection, there’s always gold. As everybody sneers, it offers no yield. But if yields elsewhere are negative, zero begins to look like a good deal.
And there’s no doubt it offers better capital protection than today’s funny money. That’s probably why it’s up 15% since January 1.