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.

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. 🙂

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. 🙂

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? 

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.

So what can you do about negative real rates? 

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. 😉

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Random Useless Fact:

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