The central banks of Japan, the EU and several other countries have implemented negative interest rate policies for some years and the Bank of England (BoE) says it will explore how this could work in the UK, should it ever be needed.

With the current base rate at 300-year lows of 0.1%, we now discuss what negative rate policy might mean for investors.

HOW NEGATIVE INTEREST RATES WORK

The BoE’s base rate determines the interest rate it pays to commercial banks that hold money with it.

The base rate influences the rates those banks charge people to borrow money or pay on their savings.

If the base rate were to move to a level such as minus 1%, then in theory for every £10 million of reserves held with the BoE a commercial bank would pay £100,000. In practice, rather than pay the interest, the BoE gives back the collateral minus the interest cost.

The goal of a negative interest rate policy is to create disincentives for banks holding excess reserves and instead encourage more lending. This is expected to increase economic activity and potentially boost growth and inflation. That’s why some economists see negative interest rates as a continuation of traditional monetary policy.

NEGATIVE BOND YIELDS ARE NOT NEW

The level of the base rate affects the cost of money across the economy and lowers the cost of servicing debts for corporations. In fact, low interest rate policy and quantitative easing has resulted in negative bond yields in shorter dated UK government bonds and corporate bonds out to five-year maturities.

The UK first issued negatively yielding bonds in May this year when the Treasury sold £3.8 billion of three-year gilts at minus 0.003%. You might assume that finding investors willing to part with their cash would be a struggle, but in fact the issue was twice oversubscribed.

HOW ARE NEGATIVE INTEREST RATE BONDS ISSUED?

UK government bonds are IOU’s issued by the Debt Management Office on behalf of the government in exchange for cash. They pay a fixed amount of interest over a specific period; at maturity the investor cashes in the bond for its original face value (also known as ‘par’).

It’s not actually possible to pay negative interest, so the way it works is that the bond is sold to investors at a premium to par and redeemed at par. If the interest payments don’t sufficiently compensate investors for the premium paid on purchase, they are guaranteed to make a loss on maturity.

Believing interest rates will become more negative in future, institutions would happily purchase negatively yielding bonds (the coupon or yield moves inversely to price) in the expectation that the premium to par would move higher, locking in a capital gain, as long as it is sold before maturity.

WOULD IT COST INDIVIDUALS MONEY TO SAVE?

With interest paid on instant access savings accounts already as low as 0.01%, some banks could decide to charge customers for holding their cash. They might take the view that a good proportion of customers save money for a rainy day and are more concerned about the security of the cash rather than the level of interest earned.

It is always worth bearing in mind that when interest rates are below the rate of inflation, the purchasing power of your savings diminishes over time. This means whatever you were saving for may have moved beyond your original expectation.

Denmark has had negative interest rates since 2012 and in August 2019 Denmark’s third largest lender Jyske Bank imposed negative interest rates on customer deposits over $1 million.

The worry for the UK financial regulator is that negative interest rates may result in retail customers closing savings accounts to seek out riskier products promising higher income.

WHAT ABOUT MORTGAGES?

Denmark has also introduced mortgages with negative interest rates, which means in practice the borrower pays back less than the original loan. Jyske Bank offered 10-year mortgages at a rate of negative 0.5%.

However, so far in the UK this type of product isn’t available. It’s always important to read the terms and conditions of financial products and in most cases there are limits built into the product. In addition, some lenders have products which specify that rates can only move up.

ARE NEGATIVE RATES GOOD OR BAD FOR SHARES?

In theory shares could benefit from negative interest rates because the discount rate that institutional investors use in their discounted cash flow models could be lowered to reflect a minus risk free rate.

However, this approach is based on valuing shares on very long-term future cash flows, so you would need to implicitly assume that interest rates will remain below zero for the next 20 to 30 years in order to justify taking this measure.

In addition, if the central bank policies are successful in raising economic growth and inflation, interest rates will rise over time, creating a headwind rather than a tailwind for share valuations.

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