Several important central banks—most notably the European Central Bank and the Swiss National Bank—have recently broken the “zero bound” for interest rates by moving their official policy rates decisively into negative territory, causing rates on some money market funds and wholesale deposits denominated in those currencies to also go negative. At this pace, it may only be a matter of time before retail depositors in these countries are also penalized on their liquid savings and consider withdrawing cash from their bank accounts to stuff under the mattress. More seriously, these policies are the symptoms of a deflationary malaise still present in some parts of the global economy. They are also the cause of potentially dangerous misallocations of capital and underpricing of risk. The fact is, the investment business is not set up for the Alice in Wonderland world of negative rates.

As the capital markets line has come down to around zero or below for the “risk-free” rate, this implies a reduced return for any given level of risk (if defined as volatility). But investors require—and have constructed portfolios on the basis of—a certain rate of return, which they are less likely to obtain from today’s starting position. To a certain extent, some of the long-term returns to be reaped from various asset classes, and most spectacularly government bonds, have been brought forward and already consumed.

The reach for return by investors with rigid targets has arguably several negative effects. First, investors are increasing allocations to riskier or less liquid assets in an attempt to meet budgeted returns. Second, the search for yield results in the compression of risk premia, most visibly in the case of some credit. Euro-denominated credits, for example, which we view as very overvalued, provide an option-adjusted spread of only 75 bps, well below their long-term average of 134 bps. Third, investors seeking to escape negative rates and yields are tempted to switch into longer-dated bonds that still provide positive yields. In the Eurozone, this means buying core government bonds beyond six years. This may work while short rates stay negative, but builds in considerable duration risk that could more than wipe out the yield advantage when rates turn positive. Last, but not least, negative rates may induce some investors to increase equity allocations for the wrong reasons, given their healthily positive dividend yields.

Fundamentally, all these add up to a probable underpricing of risk and a skewing of asset allocations away from that of a truly diversified portfolio—from a risk perspective. So why are investors accepting negative rates and their perverse effects? To some degree, they have little option as the central banks control rates and, by some measures, the quantity of money. And in regions such as the Eurozone, which has subsided into outright deflation (the year-over-year change CPI is -0.3%), zero or negative nominal rates may still be marginally positive in real terms, as the Japanese demonstrated over many years. There are other good reasons for accepting negative nominal rates, including the scarcity of perceived safe havens. To the extent that investors see deposits in Swiss francs as a reliable store of value in a currency that has a long track record of appreciating against other paper currencies over time and is seemingly immune to geopolitical turmoil, it is rational to pay some sort of insurance premium to park at least part of one’s assets. Less convincingly for long-term investors, the “greater fool” theory may comfort some into buying negative-yielding bonds in the hope of eventual re-sale at even higher prices.

Of course, at the margin, some investors are not entirely accepting of this state of affairs and are voting with their feet. This has worked most dramatically in the case of the rapidly-depreciating euro. Relative interest rates have always been a strong driver of the “carry trade” in the foreign exchange markets, and the leap-frogging of rate cuts into negative territory by many central banks illustrates their desperation to maintain their countries’ competitiveness in a global economy plagued by inadequate demand.

In the end, the hope is that negative yields are an exceptional and temporary phenomenon and normal service will resume as global demand recovers. Either way, investors might stop to consider whether some of their return assumptions are still compatible with the level of risk they have signed up for, and if not, adjust accordingly.

Stephen Saint-Leger is a Managing Director on the Cambridge Associates Global Investment Research team.