Interest rate rise – it had to happen
Well, well, well, it seems the ‘low-interest rate party’ we’ve been enjoying for the past 10 years is now calling for ‘last drinks’ A recent Bank of England interest rate rise, their first in a decade, probably heralds the beginning of the end, for the greatest period borrowers have had in history. (Cash investors, not so much)
This interest rate rise, now means both the US and the UK have reversed the rate trend set as a result of the GFC. And no doubt countries of the European Union are already spraying WD40 on their “rate increase levers” in readiness for their own rate hikes!
Australia can’t be too far behind either. Certainly not in the near term, but in today’s global economy, interest rate trends are usually uniform in nature. Watch carefully towards the 2nd half of 2018!
Sadly like any boom, we get a bust, and this period of historically low-interest rates is no different. Pretty soon, being able to borrow money at 4% will be the new “I remember when…” just as “I remember when interest rates were 17%” was for previous generations.
So what is the strategy when interest rates rise?
It really comes down to how quickly interest rates will rise as to what investors should be doing to prepare. Firstly, there is absolutely no need to panic. History teaches us that rate increases are usually slow and steady, rather than huge leaps. Increments of 0.25% are the norm. So a gradual rising of rates, which is expected, shouldn’t hurt the stock market. Dividend investing strategies should remain in place.
Alternatively, though, any steep hikes could spark a major correction. If rates were to rise significantly investors would pour out of the market in favour of the safety of cash. Let’s face it, if you can earn 5% on a cash deposit in the bank, then why take the risk of investing in equities.
As far as particular sectors to look at when interest rates are on the rise, ‘banks’ are a standout. Reorganising, downsizing, de-risking, and re-engineering core priorities (and all the other terms they use!) would have made for a lot less fat in this sector. So a rise in interest rates will increase their margins and profit. They have spent the last 10 years getting their house in order, so they should reap the benefit now.
You could also look at dedicated financial services companies who manufacture annuities. They would have plenty of long-term annuities on issue, locked in at very low rates. Any rise in cash investment rates will flow straight to their bottom lines.
Strangely, the housing market could also take a jump. As rates begin to climb off a very low base, an increase just might shake some of the ‘fence sitters’ enough to make a commitment and actually buy.
But what should existing borrowers do in this new paradigm?
Moving your loan to a fixed rate is always an option but it’s not as cut and dried as it’s made out to be. Keep the following in mind when you’re researching any move.
Let’s say interest rate increases do indeed follow history and average 3 increments p.a. of 0.25% or 0.75% overall per year. Go and look at some fixed rate loans currently on offer. Are they higher than you’re currently paying? Most probably yes. Will they still be higher if we do indeed get a 0.75% annual increase? Most probably they would be.
Most fixed-term lending is are usually 1 or 2-year terms.With gradual rate increases, it can take a while for a variable rate to actually reach the fixed rate. So is it really worth moving? Add in the fee’s and it probably isn’t. Oh, and don’t forget, always compare your rate with the advertised “comparison rate” because that’s the one with all the extra charges loaded into it!
Bond investors – The bond market is affected when interest rates rise
Interest rates have always been considered the biggest risk when deciding on bond investing. Upward trending rates leave bondholders in a dilemma whether to keep their investment to term or sell out and buy in at higher returns. But unfortunately, the only way to attract a buyer for a lower interest bond is to discount the face value. And this results in a loss to the bond seller – ouch!
For example, imagine investing $5,000 directly in a bond with 10-year duration and a coupon rate of 3%. Suddenly, one year into the term, the current interest rates have increased to 4%. Now, you can sit back and just take the guaranteed 3% for the remaining nine years of course.
But if you are drawn to higher rates for whatever reason, you can also sell your bond. You do this on the secondary bond market. Unfortunately, when you do put your 3% bond up for sale you are competing against similar bonds that have been issued at 4% pa.
Therefore if you are eager to sell, the only course of action you have to attract a buyer is to put your bond on ‘special’; just like any retailer wanting to move stock. But you can’t alter the term or the interest rate as they’re locked in. So the only course of action you have is to discount the capital value. That’s right; you sell your $5,000 investment for $4,500. Meaning the buyer will get your $5k face value bond for the sum of $4.5k. So you have just taken a $500 loss!
Now I can assure you the considerations when doing this type of transaction are both detailed and complex. But be assured within the bond market it is a very common daily transaction.
The advantage to the buyer of a lower interest rate bond, is actually how the yield or return is recalculated. Because they are buying a fixed return on a fixed amount the calculated dollar return when contrasted against the cheaper price paid, actually increases their return in percentage terms. (Think about it!)
For the seller, they take an immediate loss, which may not be as much as leaving their funds invested to run to term, when compared to current market returns on offer.
By the way, on the other hand, when interest rates start to fall, bonds are fabulous investments. If you want to sell, instead of discounting to attract buyers you actually have eager buyers lining up to get hold of your higher interest rate bond. Hence you can ask for a premium on the face value, and therefore a capital gain – yahoo!
Rising interest rates are a macro-environmental factor that will always shift the opportunities for investors. As I have said in previous posts, you need to keep abreast of changes to ensure you take advantage of the opportunities or calamities they might present.
Let me know if you see some market opportunities as a result of interest rate rises as I am always keen to hear your thoughts.
Thanks for reading and see you next time. Homepage