By Scott Ronalds

In this turbulent time, we thought it would be helpful to address a few of the more commonly asked questions we’re facing from investors. We discussed the impact of cheap oil the other week and continue our series today with the topic of negative interest rates.

What are negative interest rates?

It sounds like an oxymoron – how can interest rates be negative? But negative interest rates occur when a country’s central bank sets its main interest rate below zero. When this happens, lenders such as financial institutions have to pay the central bank to keep their money on deposit rather than collecting interest payments. In essence, negative interest rates serve as a penalty to financial institutions for holding cash with the central bank instead of using it for other purposes.

If this were to happen in Canada, TD Bank (or any other bank), for example, would have to pay the central bank (the Bank of Canada) to hold its money, rather than receiving interest on its deposits.

Countries implement negative interest rates to stimulate their economies when most other options are exhausted. In theory, negative rates encourage banks to lend or invest more, rather than holding onto cash. An article in the Globe and Mail does a good job of explaining the concept.

Negative interest rates can benefit consumers and businesses because the cost of borrowing falls. The downside, however, is that savers are penalized. As well, as a Bloomberg article explains, negative rates can potentially harm an economy if people hoard cash, thereby “disrupting the money markets that help fund financial institutions.”

While we have never had negative interest rates in Canada, a number of countries around the world are experimenting with them, including several European nations and Japan.

How do negative interest rates impact bond investors?

The Bank of Canada’s key lending rate is currently set at 0.5%. If the Bank decided to cut the rate to zero or below, bond investors would likely benefit from an initial boost to prices (when rates fall, bond prices rise, and vice-versa), but would be advised to lower their longer-term return expectations.

The lower interest rates are, the lower the payments investors receive for lending their money. Further, when interest rates inevitably rise from rock-bottom levels, bond prices will be negatively impacted. For bond investors with a medium to long-term investment horizon, negative interest rates are a negative indeed.