Demographics squeezing yields

The data shows that since March 2016, the official key interest rate of the European Central Bank (ECB) has remained at zero percent.^[1] Originally implemented as a response to the 2008 financial crisis and the resulting problems affecting the euro area, it has once again been extended – this time due to the Corona pandemic. The ECB plans to continue this strategy until the inflation outlook for the euro area “robustly converge(s) to a level sufficiently close to, but below, two percent.”^[2] This could take a while.

For investors, this monetary policy means that German government bonds are currently not generating any returns, in addition to other effects. For ten-year bonds, yields slipped into the negative in January 2016 and, after a brief slight recovery, slid below zero again in early 2019. One of the reasons for this was the ECB’s bond purchases, another was investors seeking secure investments. High demand drove up the prices for these bonds which, conversely, leads to lower and potentially negative returns.

The challenge of demographic change

The ECB, and its efforts to boost the euro area economy, is not solely to blame for this. Generally speaking, the returns provided by fixed-income securities issued by nations with a good credit rating have been in decline since the early 1980s. One factor is the slackening of the raging inflation that occurred back then. This allowed key interest rates to be reduced numerous times. Another one is the market’s expectations regarding inflation, which play an important role in determining prices in the securities market – and thereby also the yields of these bonds, whose rise usually corresponds with inflation.

Are there, however, also other factors responsible for the overall low yields? Central banks and economists have been tracking this phenomenon for some time now. They have identified another trend that can have a negative effect on yields: demographic change. An aging population, especially in industrialized nations, often accompanied by a slowdown in population growth or even a decline in overall population.

Global savings glut?

Two large-scale studies were conducted in previous years to test this theory, and the results were published by the ECB^[3] and the German Economic Institute (Institut der deutschen Wirtschaft)^[4] in Cologne, Germany. The scientific research is taking a slightly different approach but reaching the same conclusion. The German Economic Institute study confirmed the suspected trend and determined that the persistently low yields are not part of the typical interest rate cycle familiar in monetary theory.^[5]

The economic analysts in Cologne drew attention to three theories^[6], among other factors, that could explain this phenomenon:

The theory of a global savings glut assumes that for quite some time now, more capital has gone into savings worldwide than into corporate investment. The former head of the U.S. Federal Reserve, Ben Bernanke, sees as a cause the growing urge to put more money into savings in response to the increased life expectancy of an aging population. These people want to put enough money aside for their expected longer retirement. Because the availability of capital exceeds the demand, the price of obtaining this money ‒ the yield ‒ is generally lower than in the past.

The theory of demographic change therefore predicts that the level of financial assets saved for retirement and other purposes will increase more rapidly than the demand for investment – which, in turn, will continue to depress yields in the long term. The slowdown in population growth worldwide^[7] will reduce investment needs. Supplementing this theory is the theory of secular stagnation proposed by, among others, Larry Summers, former head of the World Bank. This theory states that a slowdown in population growth and relatively lower prices for capital goods can sustainably lower yields.

Downward trend – vanishing returns for German government bonds

Except for an interim high after the German reunification, the current yields for government bonds issued in Germany has been declining since the 1980s.

Analysts at the German Economic Institute expect demographic changes to have a noticeable and lasting effect on yields. They therefore expect yields to remain lower than they were prior to the late 1980s. Using a mathematical model, they predict that in Germany, for example, the actual yield will only rise from -0.4 percent to +0.5 percent in the years 2016 to 2035, and then fall to zero again by 2050.^[8]

Alternatives to government bonds

From an academic viewpoint, there are numerous indications that the low yields ‒ especially in developed industrialized nations ‒ are not a fleeting phenomenon but rather an indicator of something structural. It can’t be completely ruled out that yields may rise from the current lows, but these spikes will likely never raise yields to prior levels.

How do these issues affect savers? Investors waiting for returns to increase in the hope that they can someday build sustainable wealth using investment-grade government bonds will most likely be disappointed. This is especially true for young savers, who cannot rely on such bonds to deliver the compound interest effect needed to save for their future retirement. However, there are still alternatives offering the opportunity for higher returns. Investors will need to accept more risk and, for example, invest in fixed-income securities from emerging markets or switch to corporate bonds. Equity funds with a diverse focus and various risk profiles could be a good choice.