Economic Effects of Low Interest Rates Experiments by Global Central Banks

Abu HanifUniversity College London

Department of Statistical ScienceMSc Statistics

This project was conducted under the supervision of Mr Dieter Girmes. We had weekly meetings to discuss ideas of how and where to focus the direction of my project. I would like to thank him for his expertise and his assistance in helping me research this topic.

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Abstract..................................................................................................................3

Introduction............................................................................................................31.1. Overview on interest rates..................................................................................3

1.1.1. What Is Interest and Where It Is Used?..........................................................31.1.2. Effects of Interest Rates..................................................................................31.1.3. The Concept of Negative Interest Rates..........................................................4

1.2. Risk Free Return and Risk Premium.......................................................................61.3. Impact On Pensions and Pension Fund Firms........................................................7

1.3.1. Could There Be a Taper Tantrum....................................................................81.4. What Happens When Interest Rates Begin To Rise?.............................................81.5. Asset Allocation of Pension Fund Firms...........................................................101.6. Bond Yields and The PPF..................................................................................111.7. Central Bank Interest Rate Predictions................................................................121.8. Brief Overview of US inflation..........................................................................13

Statistical Methods...............................................................................................14

Exploratory Data Analysis.....................................................................................143.1. EU Bonds of Various Different Maturities............................................................14

3.1.1. EU Correlation Plots......................................................................................153.2. US Bonds of Various Different Maturities............................................................17

3.2.1. US Correlation Plots......................................................................................183.3. UK Bonds of Various Different Maturities...........................................................19

3.3.1. UK Correlation Plots......................................................................................20

Solutions...............................................................................................................214.1. US Bonds............................................................................................................. 22

4.1.1. US 5 & 10 Year Bonds With Risk Premium....................................................224.1.2. US AAA & BBB Corporate Bonds With Risk Premium....................................23

4.2. EU Bonds............................................................................................................. 244.2.1. EU Risk Premiums.........................................................................................24

4.3 UK Bonds..............................................................................................................254.3.1 UK Risk Premiums..........................................................................................25

4.4. UK, EU & US Prediction Models...........................................................................264.4.1. US 3 Year Prediction Model..........................................................................264.4.2. EU 3 Year Prediction Model..........................................................................274.4.3. UK 3 Year Prediction Model..........................................................................284.4.4. UK Prediction Model Focusing on 30 Year Bonds..........................................29

4.5 US, EU & UK Risk Premiums on Bonds..................................................................304.5.1. US Risk Premium on AAA Bonds....................................................................304.5.2. EU Risk Premium on AAA Bonds...................................................................304.5.3. UK Risk Premium on AAA Bonds...................................................................31

Conclusion............................................................................................................32

Bibliography..........................................................................................................33

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Abstract

Negative interest rates seem inevitable; they are affecting pension fund firms, pensioners and investors across the globe in various developed countries. Pension fund firms are facing difficulties in generating revenue to keep afloat and pensioners are concerned about the security of their pensions. Investors are being deterred by negative interest rates and asset classes such as fixed income securities are becoming distasteful. Longer duration fixed income securities is not attractive either even though they benefit from higher risk premiums, as these premiums seem to be negative in the future. Across the EU, UK and US fixed income security yields are predicted by the models in this project to drop below zero approximately before the end of this current decade. Risk premiums of these fixed income securities across these economies have their own unique behaviour, which is very interesting. This project finds that there are difficult times ahead and masses of pensioners; pension fund firms and investors are to be effected.

Introduction

1.1. Overview on interest rates

1.1.1. What Is Interest and Where It Is Used?Interest rates are payments that are made by the borrower to the lender on top of what they borrowed, akin to a premium that is paid to the lender over time depending on various different factors (Heakal 2011). Interest rates are affected by the period of the loan, inflation, the government and the credit worthiness of the individual, company or country, which are determined by credit rating agencies or a credit score for individuals.

Interest can be categorised into two types, simple interest and compound interest. Simple interest consists of a simple calculation where the amount paid for servicing the debt doesn’t change over time. This is not the case however for compound interest as the debt owed will grow exponentially over time as the interest from a previous period accumulates (Picardo 2016).

1.1.2. Effects of Interest RatesIn economics, governments use monetary policy, the manipulation of the interest rate in order to achieve certain objectives. The most common, the Monetary Policy Committee (MPC) aims to achieve an inflation rate of around 2% (Pettinger 2015a). Inflation is the gradual increase in prices of goods and services (Anon 2016k). Depending on the circumstances increasing or decreasing the interest rate helps to achieve the inflation rate. For example if the MPC want to implement an expansionary monetary policy they can decrease the interest rate to make loans and borrowing money more attractive to consumers and businesses. In turn this leads to increased consumption and expenditure leading to a growth in the economy and the inflation rate to rise (Moffatt 2016). Contractionary monetary policy can be implemented if the government wishes to achieve the opposite result. The above two policies affect the inflation rate by increasing and decreasing it respectively

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(Moffatt 2016). An increase in interest rates effects the exchange rate, as this will cause the value of the currency to strengthen and increase its exchange rate, this in turn makes exports less attractive and imports more attractive. Decreasing interest rates will cause the exchange rate to fall and the demand for exports will increase instead (Anon 2016g).

Changes in interest rates affect mortgages and other borrowing products offered to consumers by commercial banks (Anon 2015b). Mortgages usually have two most common products, a fixed rate and a tracker rate. A fixed rate of interest is where the borrower pays a fixed rate of interest per annum on their mortgage whereas a tracker rate tracks the Bank of England’s interest rate where changes made to that will have implications on the interest on this particular type of mortgage (Anon 2016h).

In regards to investments, the asset class that is immediately affected by interest rates tends to be the bond market. As interest rates decrease bonds become less attractive as their pay out on maturity decreases. However if a bond is purchased that has a pay out of 4% but the interest decreases to 3%, the bond becomes more attractive as its price increases. The bond price decreases if the interest were to rise to 5% and, hence the bond becomes less attractive in this case. Real estate becomes more attractive to investors as interest rates decrease, as the cost of borrowing is lower and vice versa (Anon 2007).

Increasing interest rates will also affect stock prices as companies listed on the stock exchange need to account for the increased costs of servicing their debt. Once investors see this, it affects the volume of investors buying and selling the stock and so more will sell on bad forecasts. This may lead to a fall in the stock price listing leading to a new equilibrium price based on the supply and demand for it (Mueller 2015).

1.1.3. The Concept of Negative Interest RatesOne very interesting area that I will discuss here are natural and negative interest rates. Interest rates have been nearly on a linear downwards trend for the past 27 years, the interest rate in 1989 peaked at 14.875% but since then it has gone down to an all time low of 0.5% in 2009 and has stayed at this rate for the past 7 years in the UK (Anon 2016p). The natural interest rate is the interest that is required to be set that neither causes the economy to shrink or boom excessively, it is an interest that keeps the economy at an equilibrium state and one of the prominent objectives of monetary policy is to find this natural interest rate. (Pettinger 2015b).

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1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 20180

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7 Different Central Bank Interest Rates

UK

EU

USA

Year

Inte

rest

rate

Figure 1.1. – Different Central Bank Interest Rates Across 17 years. Data Adapted From: (Anon 2016m; Anon 2016i; Anon 2016p)

Figure 1.1. is an interest rate graph of three central banks. USA, UK and the EU, it shows interest rates from the period of 1999 till 2016. We can see that across this 17 year period the interest has had bumps but seems to be on a downward trend. The US interest rate took a severe battering in 2000 and dropped harshly in a few years from 6.5% to 1%. In the recession the UK and US interest rate dipped well below the EU interest rate initially but eventually all 3 central banks had their interest rates almost very similar to each other. What we can see now is that the US interest rate in 2016 is beginning to rise slightly but whether this is sustainable is a significant question posed. This increase I believe is because of the fact that the US has taken their foot off of quantitative easing exercises (Kearns 2015).

The reason for the use of negative interest rates is due to the failure of expansionary monetary policy and quantitative easing and is a clear sign of stress within an economy. Quantitative easing is where governments inject money into an economy by purchasing a range of financial assets such as pension funds, commercial banks and insurance companies to name a few. What this does is it increases the prices of these assets that are purchased and also causes the yield on them to decrease, thus this leads to the cost of borrowing to decrease as the yields for these firms continues to fall (Anon 2010). This in turn leads to an increase in aggregate demand, which consists of consumer spending, government expenditure, investments and exports (Anon 2013).

Negative interest rates mean those who hold money in banks whether that is an individual keeping money in a savings account or a commercial bank holding money with the Bank of England, they will be charged for keeping this money in the bank (Anon 2015c). This is done, as the government wants to deter individuals and banks

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from saving and holding on to their money. They want to encourage commercial banks to lend to businesses and individuals and generally want people to spend in order to boost growth and increase aggregate demand (Walker 2016). The Bank of Japan and the European Central Bank (ECB) have already implemented this strategy. The ECB have reduced interest rates to -0.1% however the concern is that this will begin to squeeze the profit margin of commercial banks and depositors may be deterred from saving their money with banks and may end up stashing their money under their mattresses (Shotter et al. 2016). There is also the fear of deflation as in the Eurozone inflation fell 0.1% in May 2016 (Anon 2016f). If it continues to decrease, consumers may stop spending as they may predict that prices will continue to drop and thus this will lead to a continued decrease in the size of the economy and will cause a shift inwards of the production possibility frontier. This then brings on the risk of increased unemployment as a result (H.C. 2015).

1.2. Risk Free Return and Risk PremiumAn interesting area when it comes to investing is the risk free return. Risk free return is the rate of return an investor can expect to gain without putting his investment at risk of losses; it is also described as where the actual return is going to be the same as the expected return (Anon 2012a). For example if a bond is purchased and its expected interest pay out is 3% over a 5-year period, then its actual pay out is 3% after this period. What can also be said about risk free return is that it is not correlated with investments that are risky for example equities or exchanged traded funds. Something to note is that for certain asset classes it is more difficult to calculate a risk free rate for example equities as oppose to bonds (Damodaran 2008).

One important concept that should be mentioned is the Sharpe Ratio; this is a means of calculating the risk premium. This ratio outputs a value, which tells us the standardised return, which is made in excess of the risk free rate. Figure 1.2. shows the formula which is used to calculate this:

The risk premium is the extra amount the investor is rewarded with for taking a bigger risk in regards to their investment (Anon 2009b). For example a bond that is issued by the government will pay a smaller risk premium as oppose to a bond issued by a less reputable firm as they will have a higher risk of defaulting when it is time to pay out on maturity. The Sharpe Ratio can be used to compare different investments, if you compare two investments A and B and of the two A has a higher Sharpe Ratio than B, this tells us that A has a higher risk premium and it is a better investment (Sharpe 1994). However sometimes this may not be because the

Sharpe Ratio = r p−r fσ p

where:r p= Expected portfolio returnr f= Risk free rate of returnσ p= Portfolio standard deviation of portfolio return

Figure 1.2. - Formula of Sharpe Ratio, Data Adapted From: (Anon 2012c)

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investment decision was a smart one but may be because the investment A may have been riskier but the Sharpe Ratio also explains this differentiation.

As a result of negative interest rates, Sharpe’s Ratio no longer provides us with useful information because we end up with negative Sharpe Ratio’s and they tell us that the risk free assets are more attractive in comparison to assets that contain a risk premium (Anon 2009a). We also have the concept of default risk premium where this is the extra amount paid to the investor for investing in a company that is more likely to default on a payment for example when paying out on a corporate bond on maturity (Anon 2016j).

1.3. Impact On Pensions and Pension Fund FirmsAnother significant aspect of negative interest rates is how they impact pensions and pension fund firms. Pension fund firms have between 60-80% of their investments in bonds. While the remaining 20-40% is diversified over other asset classes such as equities and alternative investments (Anon 2011). The problem negative interest rates poses to pension fund firms is that they no longer can service the debt without incurring a loss and the value they have gained after their bonds have matured is less than the original amount invested. Hence why a lot of pension fund firms are concerned as they have to rethink their strategy of generating income and staying afloat as this current situation means they are struggling to make a profit and are currently losing money (Mather 2016). This is also a similar problem for insurance companies. If the interest rates stay negative and continue to decrease, this will risk the collapse of pension fund firms and insurance companies (Flood & Marriage 2016). This is due to the legal requirement pensions firms face as they have to pay the pensioners when required regardless of whether they are making a loss or not and the fact that a minimum percentage of their assets must be held within government bonds. The percentage of these government bonds that must be held within these pension funds is very high and varies between different countries. For example pension firms in France must hold a bare minimum of 50% in EU government bonds within their pension funds (Anon 2015e).

Moreover rebalancing their portfolio from bonds to equities or other asset classes is not feasible because of the current economic turmoil since investors are surrounded by uncertainty and markets are volatile as a result of the UK exiting the European Union (Warner 2016). Safe havens like gold may seem attractive to pensions firms but they also carry their own set of problems, gold is not an income generating asset like other assets such as equities (Cumbo 2016). In order to profit from gold, a pension fund firm will have to buy gold and then sell it at a higher price on the market in order to generate a profit (Light 2016). Unlike gold, equities reward the investor through dividends for owning the stock whilst also benefiting from growth (Anon 2016a).

Therefore pension firms have begun to become more creative due to their desperation in how they generate revenue, some of these firms have invested in buying car parking spaces in Gatwick airport as a form of alternative investment (Anon 2015d). They have also been looking into buying tollbooths (Respaut 2016).

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1.3.1. Could There Be a Taper TantrumOne significant thought that could cloud investor’s minds is what will happen if negative interest rates disappear and whether this will result in a taper tantrum. A taper tantrum is the effect that potentially could occur when quantitative easing is slowly eased off and how this affects markets in the short run. An example of this is the Federal Reserve was using quantitative easing to pump money into the US economy; they purchased bonds in order to boost economic growth. For example this was accomplished by $85 billion bond purchases in 2012 (Neely 2014). However slowly the amount injected by the Federal Reserve was tapered after indications in a press conference in June 2013 until quantitative easing came to a stop in November 2014 (Kearns 2015).

As a result of this conference in June 2013 US bond yields increased substantially. It increased the bond yields by approximately 0.35% across a 3-day period as shown in Figure 1.3. This was as a result of investors panicking and beginning to take their money out from the bond market.

Gradually across the year of 2013 global markets reacted to this conference and they all began to shed massive amounts of money and caused multiple world currencies to decrease in value. This varied depending on the country, some countries such as Russia shed as little

as 9% in their currency, the Russian Rouble, however other countries such as Turkey were not as lucky as they lost over 22% in their currencies value (Dorsch 2014).

In my opinion I believe when interest rates begin to rise, this will cause a potential taper tantrum as this will cause uncertainty in markets. Just recently the UK voted to exit the European Union and this caused an almost 6% decrease in the FTSE 100 index which was an overreaction (Anon 2016d). However on the 30th of June 2016 the Bank of England hinted at a potential cut in interest rates and this caused the markets to soar and the FTSE 100 gained substantial ground with an increase of almost 10% because of improved export chances (Anon 2016o). So if the opposite occurs and interest rates go up, there will definitely be a significant impact.

1.4. What Happens When Interest Rates Begin To Rise?One question that surrounds us are what will happen when interest rates begins to rise again, what and when will this happen? Recently an interesting article on CNBC has pointed out that more tangible assets such as investing in the stock market are becoming less and less safe to invest in and is warning of diminishing returns as a result, it also voices its concerns of central banks such as in the US are struggling to

Figure 1.3. – US 10-Year Bond Yields Around The Conference Period, Data Adapted From: (Neely 2014)

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stimulate sufficient growth in order to keep investors enthusiastic and unconcerned about investing (Cox 2013). The US actually saw a contraction in the size of its economy and this is the opposite result the Federal Reserve is attempting to achieve as they have been pumping in billions of dollars into the economy through quantitative easing and through printing huge sums of fresh money (Cox 2013). This is a problem as this is causing investors to shy away and begin to invest in commodities and gold to protect themselves from losing money through inflation, some investors are also considering investing in various different countries too (Nandakumar 2016).

This is a severe concern for pensions firms as this means that not only are they crippled by the negative interest rates, as they have to hold a specific percentage of bonds, which are not yielding a profit, but they also don’t have any faith in stocks as this credit supernova looms over them (Anon 2015e; Cox 2013). What’s more is that even real estate is a concern as recently an article in the Financial Times; investors are predicting the end of the credit cycle (Rennison & Childs 2016). This is where borrowing is easy or cheap in an economy (Anon 2016c). This is promising for hedge funds but not so much for pension funds in the short run as this means real estate value will potentially drop if interest rates begin to rise and this means pensions firms investing in real estate is not a good idea either (Schoen 2015). Pensions firms also will suffer for the period they hold the negative yield bonds until interest rates are high enough for them to make a profit again (Borin 2016). In the long run once interest rates have potentially risen and the negative yield bonds have matured and are no longer existent in their portfolios, this will probably be the start of a new era for pension fund firms and only the very best will survive this financial ice age in the short run in my opinion. Another issue is companies are having less money and are struggling to invest in infrastructure and other areas as their money is going on internal corporate pensions funds (Dakers 2015).

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1.5. Asset Allocation of Pension Fund Firms

Portfolios over the years have really reshuffled and changed in pension funds and this seems to be as a result of the oncoming pressures in the economy over the years. Figure 1.4. is a graph published by Tower Watson illustrating how pension funds across 7 countries have reallocated their assets across a period of approximately 20 years. We can see that the amount of funds allocated within bonds, cash and equities has decreased but alternative investments has been on the rise so the question we really are posed with is if this trend will continue. The fact that bonds held have decreased can be credited to the fact that governments have been relaxing the ruling on the percentages of bonds that must be held by pensions fund firms (Anon 2012b).

However the results of how assets have been reallocated in regard to the UK are quite unique. Figure 1.5. illustrates that cash held has increased across 10 years, equities held has decreased however bonds and other investments have risen. Larger changes have occurred across the different asset classes during the 5-year period between 2009 and 2014.

Figure 1.4. – Asset Allocation of Pension Funds Across A 19 Year Period, Data Adapted From: (Anon 2015a)

Figure 1.5. – Asset Allocation of Pension Funds in The UK On 3 Different Years, Data Adapted From: (Anon 2015a)

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1.6. Bond Yields and The PPF

Figure 1.6. – Positive and Negative Bond Yields Across Various Different Countries, Data Adapted From: (Konig 2016)

Figure 1.6. illustrates some countries that are currently giving out negative yields on their bonds, the UK and Norway being the exception. We can see the problem being illuminated here as more bonds become negative on maturity, this is a significant threat for pensions firms.

The Bank of Japan has an interest rate set at 0% and Japanese government bond yields have continuously fallen to the point of no return (Anon 2016b). One fear is that within 10 years, the Japanese bond market maybe gone altogether if this continues. This leads me to mention the Pension Protection Fund (PPF). The PPF is an institution where they pay compensation if pensions cannot be paid out by certain pension funds due to collapsing, bankruptcy or possibly even negative interest rates. This is a means of protecting individuals if their pension were to disappear. Pensioners are also protected by the PPF if their pensions are lost due to fraudulent reasons (Anon 2009c). The equivalent of the PPF in the US is known as the Pension Benefit Guaranty Corporation. The concern is that if interest rates rise rapidly, the bonds held by these pensions fund firms may become worthless, this will lead to a lot pension fund firms becoming insolvent and this will put a lot of pressure on the PPF to take responsibility on these pensioners who have lost out on their pensions. As a result, worst case scenario if the amount of pension debt cannot be compensated then the government will have to step in which will lead to increased government debt. This is seemingly to look more like a possibility as the UK has about 84% of pensions funds that are in deficit according to the PPF (Lewin 2016). The cocktail of low interest rates, plunges in bond yields and stocks have not helped the scenario. An alarming concern is the recent sudden rise in the pension deficit of £89bn in the period of one month from May to June. Hyman Robertson has calculated that the full reimbursement of these pensions total £925bn. The pension shortfall now stands at “£383.6bn at the end of June” (Lewin 2016). The concern is that pension fund firms will have to start selling their assets in order to meet their shortfalls within their cash flows in the future (Burgess 2016).

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1.7. Central Bank Interest Rate PredictionsRecently in a Bloomberg article, the safety of bonds in developed economies was reassured as “offering some of the safest offerings worldwide”, corporate bonds were considered the best balance of “risk and reward” and the value of sovereign bonds had been pushed “to the top” after the BREXIT results (Sivabalan & Levitov 2016). This factored in with the fact that central banks are pumping in more money into the economy to prevent a slowdown because of the EU referendum for example the UK’s central bank is “ready to inject £250bn” into the economy to keep the “UK afloat” (Rodionova 2016). Another issue is wealthy individuals from emerging market economies are buying bonds from developed countries such as the UK because they want security in regards to their investments, this is harmful in the sense it forces interest rates to stay quite low (Bury 2016). What’s more is that interest rates set in different countries with respect to the bonds they have issued are correlated to the amount of debt that country has. Grüner Fisher Investments has conducted a study illustrating this connection (Anon 2016r). The common trend was that the higher the debt the country had with respect to its GDP, the higher the interest they paid out on their bonds (Anon 2008).

Figure 1.7. – Central Bank Interest Rates In The US and EU With a 10 Year Prediction, Data Adapted From: (Anon 2016m; Anon 2016i; Anon 2016n)

Figure 1.7. is a graph showing interest rates within the EU and USA from 1999 to 2016. The 10-year prediction of the interest rate is from 2017 to 2026. This prediction was created with the aid of data from Metzler Asset Management (Anon 2016n). What we can gauge from this graph is that the interest rates are consistently rising with hardly any volatility from 2017 to 2026 reaching an interest rate of 1.5% in the USA. However in regards to the EU interest rate what we can see is that in the

01/07/2016

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initial 10 year prediction period, the interest rate continues to decrease till it hits rock bottom around 2018 at -0.5% from which then the interest rate begins to pull back and grows rapidly and reaches around 1% in 2026. The credibility of this prediction is questionable as the consistent linear downward trend seems to have been broken out off in this predictive period and this is quite difficult to believe.

I will now shed some light upon bonds. Three concepts, which are key to understanding bonds, are duration, maturity and a yield curve. What we need to know about these terms is the duration is the length of the underlying fixed income security so for example 5 years, 10 years, 15 years etc. Maturity is when this fixed income security will no longer exist and the borrower is paid back their money with the agreed interest, whether that is positive or a negative interest rate (Zoll 2012). The yield curve measures the interest paid dependent upon the length of the bond. All these concepts are interlinked and we can see this as the longer the duration on a bond, the more interest it pays due to the risk involved hence having a higher yield and is most profitable upon maturity (Waring 2015). Another significant concept we need to know about is various different risks involved such as interest rate risk. Interest rate risk is a risk, which occurs when interest begins to increase or decrease. It is where the investment value is affected as a result of this and is something very important in regards to the bond market, especially in this current economic climate (Anon 2016l).

1.8. Brief Overview of US inflation

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 20180

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-1.00%

0.00%

1.00%

2.00%

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5.00%

US Interest and Inflation Rate from 1999-2016

US Base Interest

Inflation

Time Period

Inte

rest

Rat

e %

Infla

tion

Rate

%

Figure 1.8. – US Base and Inflation Rate Across 17 Years, Data Adapted From: (Anon 2016s; Anon 2016i)

Inflation is an aspect we should now touch upon. Figure 1.8. is a graph illustrating the US central bank interest rate along side inflation rates. We can see from the graph that just like how interest rates have been decreasing in a linear trend so has inflation. Inflation seems to be correlated with the interest rate, as the interest decreases so does the inflation throughout most of the 17-year period. Now what

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we see is that inflation does seem to be heading to zero and potentially going to dip into deflation as a result in the future.

Statistical Methods

The data we looked at in order to explore this question consisted of UK, US and EU bond data. This consisted of data varying from government bond data to corporate bond data. We looked at various different maturities, this ranged from looking at 2-year bonds all the way up to 30-year bonds. The data was sourced online and was analysed to create correlation plots, regression models, prediction models and risk premium plots. The prediction models contained red zero lines to see when these bonds intersected this line and so we can get an idea of when the interest paid out on the bonds reach zero. We dealt with any missing data through the use of conventional methods, which consisted of replacing a missing future entry using a previous entry so we can work with it effectively. After we created all these plots, we made sufficient comparisons between each country and saw what conclusions we can draw from them.

Exploratory Data Analysis

This section gives insight to the daily data for bond yields and correlation plots of the EU, US and UK data comparing changes in various different maturities.

3.1. EU Bonds of Various Different Maturities

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Yield curve spot rates , (from 2 to 30)-year maturity - Government bond, nominal, all issuers whose rating is triple A - Euro area (changing compo-

sition)% pa 2y mat

% pa 5y mat

% pa 10y mat

% pa 15y mat

% pa 20y mat

% pa 30y mat

Zero Line

Time Period

%- p

er a

nnum

Figure 3.1. – European Government Bonds of Various Different Maturities With A Zero Line, Data Adapted From: (Anon 2016e)

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Figure 3.1. is a graph illustrating 6 different maturities with a zero line across a 12 year time period starting from 2004 to show us where specifically some of these maturities have crossed this zero line. We can analyse that 2,5 and 10-year bonds have already intersected the zero line and the interest paid upon these bonds are negative as of this present time in 2016. The trend seems to be continuing to decrease and thus looks like where the 15,20 and 30 year bonds are heading. We see from the graph the interest rate peaked at 5.17% for 30-year maturities on 22/09/08. Then due to the recession in 2008 the interest rate paid on bonds began to consistently decrease until we got to the current scenario now.

3.1.1. EU Correlation Plots

-0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8

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0.4f(x) = 0.690293288929643 x − 0.00105387874410116R² = 0.940878447849637

Correlation Plot of Percentage Change in 15 and 20 Year EU Bonds

Series2Linear (Series2)

15 Year Maturity

20 Y

ear M

atur

ity

Figure 3.2. – Correlation Plot of Percentage Change in 15 and 20-Year EU Bonds, Data Adapted From: (Anon 2016e)

Figure 3.2. is a correlation plot comparing the percentage change in 15 and 20-year bonds. What we can see from this graph is that there is strong positive correlation and there seems to only be only 1 or 2 outliers. The R-Squared value is very high at 0.94.

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-0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8

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0.3f(x) = 0.551732696200734 x − 0.001137506257068R² = 0.833918706300087

Correlation Plot of Percentage Change in 15 and 30 Year EU Bonds

Series2Linear (Series2)

15 Year Maturity

30 Y

ear M

atur

ity

Figure 3.3. - Correlation Plot of Percentage Change in 15 and 30-Year EU Bonds, Data Adapted From: (Anon 2016e)

Figure 3.3. is a correlation plot that looks at 15 and 30 year bonds and there percentage changes, this graph seems to have a lot more outliers but there is still a strong positive correlation. The R-Squared value for this plot is the lowest at 0.83.

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f(x) = 0.82338487555417 x − 0.000217762285992923R² = 0.940601843576987

Correlation Plot of Percentage Change in 20 and 30 Year EU Bonds

Series2Linear (Series2)

20 Year Maturity

30 Y

ear M

atur

ity

Figure 3.4. - Correlation Plot of Percentage Change in 20 and 30-Year EU Bonds, Data Adapted From: (Anon 2016e)

Figure 3.4. is a correlation plot for the percentage change of 20 and 30 year bonds and what we can see is that there is a clear positive correlation visible with only a handful of outliers and most of the points lie on the trend line. The R-Squared value is very high for this correlation plot at 0.94.

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3.2. US Bonds of Various Different Maturities

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rest

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e p.

a %

Figure 3.5. – US Government Bonds of Various Different Maturities With A Zero Line, Data Adapted From: (Anon 2016i)

Figure 3.5. is a graph of US treasuries of maturities ranging from 2 and 30 years. This graph is across a 12-year period from 2004 to 2016. I have placed a zero line as a reference point to see how close these bonds are approaching this line. Like the European graph of government bonds of the same time period, we see that there is an almost linear decreasing trend of the US bonds and will probably dip below zero like the European bonds. We can also see that the recession in 2008 had a severe impact on the return on US government bonds as they have substantially decreased from then to now, this is almost an identical scenario for the Europeans.

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3.2.1. US Correlation Plots

Figure 3.6. - Correlation Plot of Percentage Change in 10 and 20-Year US Bonds, Data Adapted From: (Anon 2016i)

Figure 3.6. is a correlation plot of 10 and 20 year US AAA government bonds, we can see that there is a very strong positive correlation with a very high R-Squared value at 0.92. There seems to only be 1 or 2 outliers.

Figure 3.7. - Correlation Plot of Percentage Change in 20 and 30-Year US Bonds, Data Adapted From: (Anon 2016i)

Figure 3.7. is a correlation plot of 20 and 30-year AAA US government bonds, again there a very strong positive correlation with only a handful outliers. The R-Squared value is very high at 0.89.

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Figure 3.8. - Correlation Plot of Percentage Change in 10 and 30-Year US Bonds, Data Adapted From: (Anon 2016i)

Figure 3.8. is a correlation plot for 10 and 30-year US AAA government bonds, this also has a very strong positive correlation with only a few outliers however this plot has the lowest R-Squared value at 0.82 but then again this is still a very high value.

3.3. UK Bonds of Various Different Maturities

Figure 3.9. - UK Government Bonds of Various Different Maturities With A Zero Line, Data Adapted From: (Anon 2016q)

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Figure 3.9. illustrates UK government bonds across an 8-year period of various different maturities. Like the US and EU we can see the UK also follows an almost linear downwards trend in regards to the interests paid upon these bonds. The graph also looks into how BREXIT has an impact, BREXIT being the vote for the UK to leave the European Union. If we look at the zero line we can see that the 2-year and 5-year bonds are very close to the zero line, the BREXIT exaggerated this even more. What we can also analyse is that after the BREXIT on 23/06/16, UK bonds took a turn for the worst and every bond, whether it be a 2 year maturity or 30 year maturity, decreased the amount of interest it was rewarding investors with.

3.3.1. UK Correlation PlotsFigure

3.10. is a correlation plot of UK AAA bonds; it looks at the change of price of 15 and 20-year bonds. If we look at the R-Squared value for this plot, we can see it is 0.97, which is a very high value. The plot also shows very strong positive correlation with few outliers.

Figure 3.10. - Correlation Plot of Percentage Change in 15 and 20-Year UK Bonds, Data Adapted From: (Anon 2016q)

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Figure 3.11. - Correlation Plot of Percentage Change in 20 and 30-Year UK Bonds, Data Adapted From: (Anon 2016q)

Figure 3.11. is a correlation plot of UK bonds, which is looking at the change in price of 20 and 30-year bonds. What we can gauge from this plot is that again we see a very high R-Squared value with few outliers and a very strong positive correlation.

Solutions

This section will explore the potential solutions to this problem and will attempt to foresee the future through the use of prediction models through studying trends and analysing this data and explaining what it could mean for the future. One concept I would like to mention again for this area is what risk premium is. This is a very significant concept and this is the reward an investor receives for taking an increased risk for buying a specific investment (Anon 2009b). This is also known as the default risk premium because the investor receives a higher return, as there is an increased possibility that the borrower may default on the interest payments or upon maturity in the case of a fixed income security (Anon 2016j).

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4.1. US Bonds

4.1.1. US 5 & 10 Year Bonds With Risk Premium

Figure 4.1. – US 5 and 10 Year AAA Government Bonds With Risk Premium, Data Adapted From: (Anon 2016i)

Figure 4.1. illustrates 5 year and 10 year US AAA government bonds with a risk premium graph attached. What we can see from this graph is that the risk premium for these bonds does not seem too volatile until the interest paid on the 5-year bonds drops significantly in comparisons to the 10-year bonds. Partly the reason the 10-year bonds pay more interest is due to the increased risk taken on by the investor. What we see is that the risk premium peaks at 169% in September 2012. This is due to the interest paid between the two different bonds has a substantially large difference between them. So as the gap between the interests paid increases between the bonds the larger the risk premium becomes. This only occurs if the difference between the 10 year and 5 year bond is positive.

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4.1.2. US AAA & BBB Corporate Bonds With Risk Premium

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e

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Figure 4.2. - US Corporate Bonds With Risk Premium, Data Adapted From: (Anon 2016i)

Figure 4.2. here illustrates corporate bonds in the US; it shows AAA and BBB bonds and the risk premium involved. As expected we can see that the risk premium rockets to 75% in 19/12/08 due to the recession as BBB bonds are a lot more risky to hold. This is also known as the default risk premium. We also notice that the risk premium is always positive and this something that is expected when comparing AAA to BBB bonds. What we also see is that corporate bonds have a linearly decreasing trend as the interest paid on them has consistently been decreasing just like US and EU treasuries. More recently in 2014 the risk premium seems to be back on its way up and this can be seen why as the gap in interest paid between AAA and BBB bonds is increasing.

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4.2. EU Bonds

4.2.1. EU Risk Premiums

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Mat Risk premium (2-5) Mat Risk premium (5-10) Mat Risk premium (10-15)Mat Risk premium (15-20) Mat Risk premium (20-30) Zero Line

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urity

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sk P

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ium

Figure 4.3. - Maturity Risk Premium Lines for EU Government Bonds, Data Adapted From: (Anon 2016e)

Figure 4.3. shows the market risk premium for various different government bonds. What we can deduce from the graph is that after the recession the behaviour of the risk premium on these bonds became erratic depending on which two bonds you compared. We can see the market risk premium for the comparison of the 20 and 30 year bonds went negative whereas the comparison for the rest were positive.

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e

Figure 4.4. – 5 and 10 Year AAA EU Government Bonds With Their p.a. Difference, Data Adapted From: (Anon 2016e)

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Figure 4.4. shows 5 and 10-year government bonds in the European Union. We can see from this graph the interest rates paid on these AAA rated bonds has linearly decreased across the 12-year period this graph illustrates. 10-year bonds performed better than the 5-year bonds across the whole time period. Since 2008 the difference in the annual return between the two bonds has substantially changed. From 2008 till 2014 the 10-year bonds were paying approximately 1% more than the 5-year bonds. Only in 2015 did the difference between the annual return of these two bonds began to decrease and is looking to head towards pre 2008 levels.

If we compare the US and EU gilts, we can see that they both follow very similar trends. The US and EU 10-year bonds almost always pay a higher annual return than the 5-year bonds. They US and EU are following the same decreasing linear trend and interest rates for both 5 and 10 year EU bonds have dipped below 0% around the beginning of 2016.

4.3 UK Bonds

4.3.1 UK Risk Premiums

Figure 4.5. – Maturity Risk Premium of UK 15 and 20-Year Government Bonds, Data Adapted From: (Anon 2016q)

Figure 4.5. illustrates 15 and 20-year maturities with its maturity risk premium. We can see across the 2 year time period of this graph, the price has been gradually been decreasing for these bonds and the maturity risk premium has been on the rise until in February 2016 where it began to slump and begin to decrease.

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4.4. UK, EU & US Prediction Models

4.4.1. US 3 Year Prediction Model

Figure 4.6. – US AAA Government Bonds of Various Different Maturities With a 3-Year Prediction, Data Adapted From: (Anon 2016i)

Figure 4.6. is a graph of US AAA government bonds with a 3-year prediction, we can see that from the regression lines, bonds in the range of 5 to 30 years will continue to decrease but 2 year bonds are looking to be on the rise. However the credibility of the regression lines for the 2 and 5-year bonds are questionable. The R-Squared value for the 5-year bonds is quite low at 0.55 but the 2-year bond has one of the worst R-Squared values at 0.02 meaning the data barely fits that regression line. In regards to the other bonds, the R-Squared value is above 0.74 for all of them, which is good as this means more than 74% of the variability in the data is explained by these models. In comparison with the European AAA government bonds graph with the 3-year prediction, we see that the US AAA bonds haven’t gone negative by 26/06/18 whereas all the European bonds of different maturities had so by 05/06/17. What we can say about the 2 and 5-year bonds is that they will most likely go negative by the end of 2018, as at August 2018 they are almost negative.

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4.4.2. EU 3 Year Prediction Model

Figure 4.7. shows European bonds which mature at different times ranging from 2 years to 30 years. The bonds that mature at 15,20 and 30 years have had a 3-year prediction in the direction in which the interest rates are heading. One particular interest of ours is when are these bonds going to go below the zero line. This is where the interest paid out by these bonds is no longer positive. From analysing this graph we found that 15-year bonds will go negative approximately 21/11/16, 20 year bonds will go negative around 31/01/17 and 30 year bonds will go negative at 05/06/17. What we notice is that across all 6 bonds, the first to go negative was the 2-year bond and the last to go negative according to our approximation is the 30-year bond. This sounds credible due to the fact that the risk premium is higher for longer duration bonds and the 30-year bond being the last to go negative sounds correct. Furthermore the R-Squared values are very high for the trend lines we predicted for the 15,20 and 30 year bonds telling us that the data are fitted quite well with the regression lines. Of the regression lines the weakest is the 30-year trend line as its R-Squared value is the lowest at 0.7 whereas the others are well above 0.8 and are very close to 1. So now what we can see is that around the end of 2016 pensions funds will no longer be able to purchase bonds that pay out a positive rate of interest so this will add more strain on to them and this will definitely mean

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sition) from 26 June 2015% pa 2y mat

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Figure 4.7. - EU AAA Government Bonds of Various Different Maturities With a 3-Year Prediction, Data Adapted From: (Anon 2016e)

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lots of pension firms going bankrupt and of those who survive will need a strong backup plan in order to generate revenue.

4.4.3. UK 3 Year Prediction Model

Figure 4.8. - UK AAA Government Bonds of Various Different Maturities With a 3-Year Prediction, Data Adapted From: (Anon 2016q)

Figure 4.8. is a prediction plot of where UK AAA bonds are heading in the next 3 years. Our aim is to predict when these maturities are going to cross the zero line, meaning when is the return on bonds going to become negative. What we can see in this graph is how BREXIT also played a part in effecting the interest paid on different maturities. We can see as soon as BREXIT took place the interest paid drastically decreased on these bonds in a very short period of time. This graph predicts when these bonds will go negative, 2 year bonds are predicted to go negative on 21/08/19, 5 year bonds on 14/01/18, 10 year bonds on 19/06/18, 15 year bonds on 29/03/19, 20 year bonds on 26/08/19 and 30 year bonds on 28/11/19. The credibility of the prediction seems credible as the R-Squared value for all the models are above 0.74 apart from for the 2-year prediction. The R-Squared value for this model is 0.35 meaning this model is questionable and may not be a good prediction.

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4.4.4. UK Prediction Model Focusing on 30 Year Bonds

Figure 4.9. - UK 30-Year AAA Government Bonds With Multiple Zero Line Crossing Predictions Including BREXIT Prediction, Data Adapted From: (Anon 2016q)

Figure 4.9. is a graph that particularly focuses on 30-year bonds and the effect of BREXIT, there are 3 regression lines attempting to predict when the 30-year bond is going to cross the zero line. One of the regression lines begins predicting from 01/07/15 and this line seems to never get close to crossing the zero line anytime soon. However the regressions lines which began predicting just before BREXIT on the 28/04/16 and upon BREXIT on 23/06/16 show a different picture and predict that the zero line will be crossed on 09/01/17 and 23/03/17 respectively.

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4.5 US, EU & UK Risk Premiums on Bonds

4.5.1. US Risk Premium on AAA Bonds

Figure 4.10. - Risk Premium of AAA US Government Bonds of Multiple Different Maturities, Data Adapted From: (Anon 2016i)

Figure 4.10. shows the risk premiums of US AAA bonds for maturities ranging from 2 till 30 years starting from a time period of 2004. We can see from the plot that the risk premium for the 2-5 and 5-10 year bond comparisons is phenomenally high. We can see the risk premium for these bonds began rising after the recession and continue to do so till it peaked for the 2-5 year bond risk premium in 2011 and at 2012 for the 5-10 year bond risk premium. The other two risk premiums have also risen after the recession but not as substantially as those previously mentioned.

4.5.2. EU Risk Premium on AAA Bonds

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Risk Premium of European AAA Bonds of Various Different Maturities

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Figure 4.11. - Risk Premium of AAA EU Government Bonds of Multiple Different Maturities, Data Adapted From: (Anon 2016e)

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Figure 4.11. is a plot of the risk premium percentages for comparing 15, 20 and 30-year bonds. What is very interesting is the fact that the risk premium graph here is very similar to that of the previous risk premium graph, which I analysed earlier in Figure 4.10. They both look very similar and the risk premium has suddenly rocketed around the same period as the US bonds did in 2016. The largest risk premium observable from here is that of the comparison of the 15 and 30-year bond represented by the blue line. What we can see is that it peaked at 255% in 11/07/2016. The risk premium for the comparison of the 15 and 20-year bond peaked at 131% at 21/07/16 and finally the risk premium peaked at 53% on 05/07/16 for the comparison of the 20 and 30-year bonds.

4.5.3. UK Risk Premium on AAA Bonds

Figure 4.12. - Risk Premium of AAA UK Government Bonds of Multiple Different Maturities, Data Adapted From: (Anon 2016q)

Figure 4.12. is a plot of the risk premiums of UK AAA government bonds across an 8-year period. It contains maturities varying from 2 years all the way up to 30 years. What we can see from this plot is that the risk premiums represented by the orange and light blue line have been acting erratic across this time period. The light blue line which is the comparison of 2 and 5-year bonds peaked at 622% on 03/09/12 and the orange line which is the comparison of 5 and 10 year bonds peaked at 285% on 08/08/16. From what we can observe all of the risk premiums peaked at two time periods.

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Conclusion

In conclusion, we have found that there are various different effects as a result of low interest rates, particularly by negative interest rates. Those who are severely affected are the pensions fund firms, pensioners and investors. In this climate where negative interest rates seem inevitable, the forecast doesn’t seem good for pension fund firms as they will have a more difficult time generating revenue to keep afloat as once interest rates are negative, they will no longer profit from holding fixed income securities and the negative interest will eat away at their funds. Pensioners need to be wary that their pensions may be lost as a result of the difficulty pension fund firms are facing as they could potentially go bankrupt in the years to come. The Pension Protection Fund will really need to take extra precautions to deal with a disaster like this as they may well end up compensating pensioners for billions of pounds. Some investors will reallocate their investments far away from fixed income securities to avoid the cost of negative interest on their holdings as they will no longer make a capital gain as a result of taking on risk and receive a risk premium whereas other investors will happily buy fixed income securities regardless of the negative interest as they will look at the negative interest as a premium paid to keep their capital safe.

In my opinion the negative interest seems to look like a stealth capital gains tax, which is clawing away at the rich and penalising them for being wealthy whereas it is contributing to the poor. It seems like the negative interest rate concept is a way to help close the gap between the rich and the poor, as the poor will benefit from negative interest rates as borrowing becomes cheaper since the poor are more likely to borrow and they can avoid negative interest as instead of keeping deposits with commercial banks, they can keep their money under the mattress as their sums of money are not that vast. Then again this poses the issue of will some investors switch their investment to different asset classes such as stocks or commodities such as gold. Investors may even invest their money into property and look for high rental yields or may potentially even move their capital out of developed countries, this will be a very interesting as too large of an outflow of capital from a country could cause a shrinkage in that country’s economy.

What’s more is commercial banks will also deter savers as they will lose money for holding any deposits with them so this only seems to be an issue for the wealthy as the poor can hide their money under a mattress as they have less wealth. In regards to pensions fund firms, the question really is are pensioners safe and what is going to happen to the future pensioners to come?

Finally I believe falling interest rates is a thunder storm to come for pension fund firms, pensioners and investors and this will be a long bumpy road and it is very difficult to say when this road will end and when interest rates will become positive again.

32

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