If I asked you to lend me money for five years, what rate of interest would you charge? 5%? 3%? How about zero? Does zero work for you? It works for me.
Or even better, how about you lend me money, and then at the end of the loan you pay me interest. In effect, the loan will carry a negative rate of interest. Does that sound fair? That’s an even better deal for me, although I might struggle to sell you on that one!
After all, who in their right mind would lend money for nothing? Or even worse, who would lend money and intentionally get back less than the loan amount? Certainly no one I know.
Yet, judging by the folks in Europe, people are lining up for this exact deal.
Two weeks ago Germany issued 5-year bonds with a negative interest rate, joining a growing club of other euro zone countries who have done the same. This might sound idiotic, but there are several good reasons why investors (pension and mutual funds, insurance companies, etc.) are jumping on this trade. A big one is the chance to make a quick profit.
When the European Central Bank (ECB) announced last fall that it would implement a quantitative easing (QE) program, everyone knew one thing for sure: It would have to buy German government bonds.
The problem is that Germany runs a nearly-balanced budget, meaning they don’t issue many net new bonds. It might sell new bonds to replace those that mature, but investors already own those bonds. If the ECB came into the market as a new buyer and there weren’t any net new bonds, then something would have to give. That something is price.
So, when Germany recently issued 5-year bonds recently, investors saw their chance and began loading up, waiting for the ECB to arrive with pockets full of cash.
The ECB joined the party on Monday with the launch of its QE program. Now it must pay whatever price the market will bear to buy bonds. If that price means a negative interest rate, so be it.
In short, institutional buyers have been front-running the ECB program. Many have no intention of holding the bonds to maturity so the negative interest rate was of little consequence.
Meanwhile, as the ECB works to devalue the euro, large institutional investors are repositioning themselves in stronger currencies, like the Swiss franc. Since they want exposure to the stronger currency, they’re willing to pay negative interest rates on Swiss bonds.
This is completely different than the reasoning behind negative interest rates in countries inside the eurozone. Germany can afford to charge negative interest rates because of demand for their bonds from the European Central Bank and the German Central Bank (the Bundesbank). Non-euro countries, like Switzerland, are charging negative rates because they don’t want the hot money flowing into their currency.
So far, this has been all about investors who buy such bonds. There’s another side to the story, and it’s spilling over into the equity markets.
Private companies have started cashing in on the good, low and negative-interest rate deal for borrowers.
Firms such as Apple have issued bonds in currencies like the Swiss franc because their cost of capital is so much cheaper than it would be in U.S. dollars. The company recently issued bonds maturing in nine years at 0.375% interest and bonds maturing in 15 years at 0.75%.
Given that 10-year U.S. Treasury bonds yield about 2.03% and 20-year bonds yield 2.33%, Apple saved itself roughly 1.75% per year in interest simply by issuing bonds denominated in Swiss francs.
As I told subscribers to my Triple Play Strategy last week, Apple will use the money it raised to buy back shares. This reduces the number of shares outstanding and, for a company with growing revenue and earnings, it can drive the stock price higher.
But there is a risk to these strategies.
If the Swiss franc falls in value, large investors who traded their euros for francs and then bought Swiss bonds will lose twice — through negative interest rates and an unfavorable exchange rate when they repatriate their money.
Borrowers such as Apple face similar risks. The company doesn’t earn enough revenue in Swiss francs to make its interest and principal payments, so it must use funds based in other currencies, like the U.S. dollar. If the franc strengthens, then Apple will pay more just to buy the francs it needs to make its debt payments.
I don’t think Apple will struggle with any of this though. The company sold less than $1 billion in bonds, and has about $175 billion in cash stashed around the world.
Still, Apple is a great example of how QE programs can drive interest rates lower, eventually translating into higher stock prices.
Little of the rising markets over the past several months was based on value or business. Instead, it was just a bunch of financial engineering cooked up inside of central banks!
Keep that in mind as you put your hard earned money to work in the equity markets, and make sure you have a strategy for buying and selling securities. We have several programs of our own — like Adam O’Dell’s Cycle Nine Alert and Ben Benoy’s Biotech Intel Trader, in addition to my Triple Play Strategy — all of which are short term, ready to move to cash at a moment’s notice. We like profits, but we also like to preserve our capital. Since a major part of this huge bull market is based on the artificially low cost of capital, eventually it will run out of steam, and run over investors who stick around too long.