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Yielding Nothing

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Yielding Nothing

As investors flock to bonds to avoid risk, pension plans face shrinking returns. March 12, 2020
Economy, finance, and budgets

On Monday, the yield on a ten-year U.S. Treasury bond hit a record low, a little more than 0.30 percent, before ending the day at 0.54 percent. This means that the real yield on bonds—minus the rate of inflation—is less than -2 percent. It used to be that a negative-yielding bond was unthinkable, but now, with every recession or bout of market turmoil, it becomes more normal. And though the drops in the stock market are getting more headlines, what’s happening to the bond market is potentially far more significant for retirees, pension funds, and the whole economy.

Bond yields dropped suddenly because of recession fears sparked by the coronavirus, and investors are seeking safer assets—a -2 percent return on a bond is better than the prospect of a 10 percent decline in the value of a stock. Some commentators argue that the bond market, and the shape of the yield curve, indicate what will happen to the economy more broadly, worrying that they are signs of a recession. Bonds, especially longer-term bonds, reflect investor expectations about economic risk, but bond traders don’t have more information on the trajectory of the virus than anyone else; they’re just responding to the same incomplete information that we all have, and pricing panic into their valuations. Yields fall as investors flee to bonds because the increased demand allows those who issue bonds to offer lower rates.

Long before the coronavirus, bond yields were trending down for other reasons. The bondholder population is older, with more savings. Regulations require financial and insurance companies to own bonds—which are safer than other assets—as a substantial part of their portfolios. A globalized economy means that countries with favorable trade balances, like East Asian and oil-rich nations, have cash to invest in low-risk assets, which they use to manage their currencies and hedge risks in the global economy. Only a few countries issue bonds considered risk-free—the U.S. and some European nations, where the odds of default are low and prices tend to be stable. This safety creates high demand for our debt.

Now that yields are negative, though, creating wealth requires taking more risk, and investors seek out less-stable assets, which may generate higher returns. The market for low-grade corporate debt is so large, and so risky, that it has become a source of concern. Investors and households have added more risk to their balance sheets, and as the market falls, we may see dislocations in unexpected places.

The current environment of low interest rates and negative bond yields is especially hard on retirement accounts. Pension funds use bond yields to value their future liabilities—and the lower the rates, the higher those liabilities are priced. Meantime, lower yields also mean lower returns, which put pension funds in a tough position. They must either accept lower returns and increase contributions or take on more risk. Many pension funds have been slow to realize or acknowledge this choice. Despite yields falling hundreds of basis points over the years—a basis point being equal to one-one hundredth of a percentage point—most public-pension funds still assume that their portfolios will return more than 7 percent annually. If their assets don’t earn this much, public pensions will face even bigger shortfalls than projected and pose a burden on taxpayers.

Things are not much better for retirees with defined-contribution plans, such as the common 401(k) account. Soon-to-be and current retirees are getting hit with a double-whammy: their stock portfolios are falling, and they can expect more risk from a volatile market. Retirement is when you should be de-risking your portfolio by moving to safer—and now lower-yielding—assets. Nobel Prize-winning financial economist Robert C. Merton argues that spending in retirement becomes more expensive because the value of retirees’ future spending—or what they can spend and count on—is valued at the risk-free rate. He speculates that lower rates could depress retirement spending.

Low interest rates are often presumed to boost the economy because they mean that borrowing money is cheap. But making low-risk assets more expensive comes with significant costs.

Photo: G0d4ather/iStock

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