Barron's Annual Roundtable Installment II

Negative interest rate is here to stay

“The real interest rate -- the rate adjusted for inflation -- is the most hidden and unobserved. It is low, even negative, and will continue to be low. We haven't talked much today about whether quantitative easing continues after June, but it doesn't matter. It has already suppressed real interest rates and allowed other asset classes, such as stocks and commercial real estate, to appreciate. Once it disappears, how long will the federal-funds rate stay at 25 basis points? That's the critical question to be answered. For a long, long time, I think. Short-term rates will stay there for at least two years and maybe three, because of high unemployment, excess capacity and, at the moment, an inherently low inflation rate. There would be no rationale for the Fed to raise interest rates other than to counter an attack on the dollar.”

Invest in overseas or companies who borrow at low interest rates

“Real short-term interest rates historically have been 1% to 1.25%. Today when Treasury bills yield about 0.2% and the inflation rate is 1.5%, the real interest rate is a negative. That is why you want to invest in countries that offer higher real interest rates, such as Brazil, Mexico and Canada.”

“I am suggesting that you get out of the U.S. dollar and get into something that offers you a positive rate of return. Whether it is bonds or stocks, get into emerging markets where the growth potential and the credit solvency are better than in the U.S. Secondly, if you don't want to own assets yielding negative real rates, why don't you borrow at such rates, or find companies that do? The government is borrowing at low real rates, which doesn't argue for owning government bonds. But if you can find companies or other structures that can borrow safely at such rates, that's a good thing for their equities.”

“Banks invest or borrow at low interest rates. They take deposits at 25 basis points and invest at longer rates, capturing the spread. If they can perpetuate that, they will build up capital and become stronger institutions. That is what the Treasury is trying to facilitate. The government is giving the banks and other levered borrowers time to rebuild their equity base and become more solvent.”

Two Recommendations

“That is a danger, but one structure that can benefit by borrowing at negative real rates is Pimco Corporate OpportunityFund (PTY, Financial), which I recommended last year and am recommending again. It returned 33% last year, including dividends, which is pretty interesting for a bond fund. How was that accomplished? With 50% leverage, which is what many closed-end funds use. PTY borrows half its money, these days at 25 to 50 basis points, and then reinvests it, hopefully safely, at 7% or 7.5%, to generate yields of 12% to 13%. It is vulnerable to rising interest rates, but to the extent that real interest rates stay low, it is well situated.”

“My other pick is a company that borrows short, relatively safely. It owns government-agency mortgages and borrows against them at about 25 basis points, which is the real thrust for both of these investments. The company is Annaly Capital Management(NLY, Financial), a mortgage REIT [real-estate investment trust]. It has a $12 billion market cap. The problem with Annaly is that the stock can go down if the company's repo capabilities [its ability to borrow short term using repurchase agreements] are diminished. That happened in 2008 when none of the banks or investment banks would take agency mortgages as collateral.”