What you should know about negative real interest rates

How negative real rates distort everything

Normally a mortgage is a liability. And bonds are a low risk, low return asset.
However when real interest rates are negative you can throw these conventional concepts out the window.

The graph below shows the difference between a government bond yield and inflation (CPI.)
The economy experiences negative real rates when the line falls below zero.

negative real interest rates can last a long time

When this happens fixed income investment returns can’t keep up with inflation.
This has overwhelming consequences for everyone.


When a mortgage you owe becomes your greatest asset

The current inflation rate is over 3%. But mortgage rates are still sub 2% for a floating rate loan.

This means if you buy a house with a mortgage today you get paid a real return on the money you borrowed.

Simply put, the cost you pay to service that mortgage is less than the value you receive from inflation eroding away your mortgage balance. Thanks to negative interest rates holding a mortgage produces wealth, net of inflation.

Real estate tends to be a terrific store of value. So you can generate returns from both your property and the debt on it, which creates a double compound growth effect. πŸ™‚

Ben Bernanke, who used to chair the Federal Reserve, still maintains a mortgage despite being a multi-millionaire who can pay it off any time he wants. If you’re ever confused about what to do with your money just look at what the people who designed the financial system are doing with theirs.


When a margin loan becomes an asset

The stock broker I use (IBKR) offers credit at 1.56% interest rate. Again, investors can get paid to borrow.

I have over $100,000 of margin debt. I used the money to buy dividend growth stocks. The dividend income I receive is more than enough to cover the interest of the margin loan. Additionally I may benefit from capital appreciation as stocks tend to outperform inflation over time. πŸ™‚


When a bond becomes a liability

In Canada the popular bond ETF (XBB.TO) has not produced any price appreciation over the last 5 years. In the United States, the Vanguard Total Bond market ETF (BND) also experienced virtually no capital appreciation.

But that’s normal, right? Fixed income investors buy bonds for the yield and stability, not capital growth.

True. Except both ETFs are yielding below the inflation rate. This means the distributions to unit holders can’t even keep up with the rising cost of living.

Why is this significant? Because it means typical bond funds today will actually be a drag on a portfolio. So anyone who has a traditional 60/40 balanced portfolio should really reconsider their asset allocation.😦

That 40% bond allocation is dragging down the returns on the rest of their portfolio – slowly eating away at the investor’s wealth. This effectively makes bonds liabilities, not assets.

That doesn’t necessarily mean bonds are bad. They can still be used for strategic positioning. But investors should understand all the risks before committing.

A sensible alternative asset class to hold is precious metals. Gold has been known to perform well in both inflationary, and deflationary times. Ultimately gold is a hedge against negative real interest rates like in today’s environment.


How did we get here?Β 

Debts today behave like assets. And fixed income investments lose value like liabilities. This is the reality of negative real interest rates – when economic growth is slow and inflation is high.

But this was no accident. Policy makers purposefully engineered this situation.

Why? Because it allows the government to get paid to borrow and spend. It’s an expedient scheme that doesn’t require fiscal responsibility. Governments can borrow money today and pay it back later when that money is worth less.

Related video: Island economics | What causes inflation.

Fortunately regular folks can also exploit this opportunity. I have blogged about this for years. When you take out a bank loan you are literally creating new credit – similar to how central banks create money. And the loan you take out today will pay you a positive return when adjusted for inflation.

Dave Chappelle meme - modern problems require modern solutions

So what can you do about negative real rates?Β 

Accumulate debt when rates are low. Pay down debt when rates rise. As Albert Einstein once said, “the measure of intelligence is the ability to change.” So continue to pursue your financial goals. But stay flexible in your approach to take advantage of new opportunities in the shifting economic landscape. πŸ˜‰



Random Useless Fact:

The median checking account balance for U.S. households is $3,400.

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Chrissy @ Eat Sleep Breathe FI
06/08/2021 3:06 pm

I LOVE this post. This is exactly why I hold as little cash as possible and use leverage to invest.

What people typically think of as “risk” (volatility) is generally not really a risk. (Unless you’re the type who freaks out and sells every time the market drops.)

The REAL risk is that your investments won’t earn enough to beat inflation… which means it’s only a matter of time before you run out of money.

Thanks for sharing such a well-written post!


[…] for negative interest rates Negative real interest rates can wreck havoc on your portfolio. It turns your debts into wealth building assets, and turn your bond holdings into liabilities that cost you […]

Beau W.
Beau W.
06/11/2021 6:57 am

Very informative article. Im going to get too rethink my bond allowance. Good job.

06/12/2021 5:21 am

Great point: “when real interest rates are negative you can throw these conventional concepts out the window.” Negative interest rates change a lot. The first time I fully became aware of was a few years ago, when I listened to the quarter results of French luxury giant LVMH. They have an extremely strong balance sheet and issued bonds, for some of them they are litterally paid. That led to a step up in their acquisition dynamic, LVMH became a growth company so to say.
Long term, with view to the world economy, I am very sceptical. There are huge risks.
Anyway. Thanks for sharing that very interesting post and
all the best.

06/12/2021 7:22 am

Very interesting perspective and it makes sense. Always a pleasure to read your posts.

Graham @ Reverse the Crush
06/12/2021 12:08 pm

Great read, Liquid! I like that Albert Einstein quote. And Bernanke carrying a mortgage says it all. I have pondered the idea of using a margin account to buy dividend stocks to pay off the interest. You have a really low rate with your broker. I previously had a margin account which I used to trade crude oil ETFs. I like your flexible approach to building wealth. Thanks for sharing.


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