(December 7, 2012) — Investors could be in line for further pain should the European Central Bank (ECB) cut already low interest rates in the Eurozone after the institution’s president warned discussions had been held on the matter.
Mario Draghi, who leads the ECB, said in a statement yesterday that senior staff had discussed whether the region needed a reduction in interest rates to help stimulate growth and recovery.
Although the committee decided against lowering the rate, analysts said if the ECB was not confident the Eurozone would make a marked improvement in the second half of next year, another cut could happen.
Low interest rates in the region have hit institutional investors in several ways. Firstly, defined benefit pension fund liabilities, which are discounted using this measure, have soared in some countries. For example the Netherlands, which had always had a well-regarded pension system, has seen several of its pension funds reduce member benefits and increase contributions from employers and staff.
Earlier this year, John Van Scheijndel, CIO at A&O Pension Services, told aiCIO: “Declining interest rates have increased the value of the liabilities substantially for our client, the industry-wide pension fund of the painters, BPF Painters. It should not hurt in the long term, but the solvency ratio is a very important ratio for the Dutch National Bank and the pension fund board. We do not want to be dependent on interest rates and market movements.”
The second issue is the impact on bond yields. As national interest rates fall, corporate bonds usually follow. Figures from data monitor Thomson Reuters this month showed high-yield bond issuers were enjoying record low borrowing rates. For investors, this means potentially lower returns on even the riskiest of credit assets when very little is performing in their portfolios. Additional data from Thomson affiliate Lipper showed European investors were holding record amounts of debt.
A note from Insight Investment last month said: “In Europe there has already been a marked compression of yields in a range of assets, including swap spreads, corporate bonds and outer core Eurozone government bonds such as France or Belgium. However, although Italian and Spanish bonds have tightened somewhat since ECB president Mario Draghi started to signal outright bond purchases in July, they remain relatively wide.”
Thirdly, falling interest rates have forced custodian banks to begin charging clients to hold their deposits. Credit Suisse became the latest to charge a fee for holding client assets in Swiss francs, due to the country’s negative rates. BNY Mellon and State Street have already begun imposing this charge on clients holding assets in Swiss Francs and Danish Kroner.
A note from Credit Suisse that was confirmed to Bloomberg, said: “Due to the current market situation and after closely monitoring the situation over the course of this year, we have decided to start applying negative credit rates on cash clearing accounts above a certain threshold…We invite our customers to keep cash balances as low as possible to avoid negative credit charges.”
With the ECB exploring the possibility of dropping rates, it’s an open question whether other central banks presiding over low rates and weak growth are considering the same tactic.