Investing in a low interest-rate environment

ANSA MERCHANT BANK LTD

 

Low levels of interest rates have prevailed over the last few years in the local and global economy, leaving income-oriented investors in a quandary. Traditional money-market funds and fixed deposits are relatively low in risk, but these safe havens are not outperforming inflation nor are they making significant contributions to your retirement funds. The question is: what should investors do in a low interest-rate environment? Focusing only on yield is a mistake. Although some investors are hungry for yield, investments with higher yields may not necessarily perform as well as others or they may take on more risk to achieve that yield.  Total return is a better measure of a fund’s success, meaning an investor should consider both capital appreciation and interest income when assessing a particular fund.  Risk is still an important consideration. While your portfolio should contain levels of acceptable risk, if you are considering a deal that sounds too good to be true, you should think again. High return with no risk simply does not exist. Given the fact that global economic reports have been anything but glowing, low interest rates are likely to persist for the foreseeable future. While this can be incredibly frustrating, do not allow a dismal investment environment to stand in the way of your investment goals. There are still strategies that can be pursued in order to achieve optimal returns during this period. 

 

 

What to consider…

 

Regardless of the state of the economy, diversification is imperative. Therefore your funds should be placed in a mix of investments. 

 

Short-term bonds or bond-based income funds

Generally speaking, bonds are associated with stable returns and preservation of capital. However, bond valuations and interest rates have an inverse relationship. If you own a bond and interest rates increase, the value of your bond will decrease. On the flipside, if you own a bond and interest rates go down the value of your bond will go up. Short-term bonds are preferable because they can be much less sensitive to changes in market interest rates than long-term bonds. herefore, should interest rates rise in the medium term (as they quite possibly can), you would have earned a fixed rate of return and your bond would be close to maturity, enabling you to redeem the total principal invested. Buy-and-hold investors can manage interest-rate risk by creating a laddered portfolio of bonds with different maturities.  A laddered portfolio repays principal at defined intervals. When one bond matures, you have the opportunity to reinvest the proceeds at the longer-term end of the ladder if you want to continue investing.  If rates are rising, then maturing principal can be invested at higher rates. If they are falling, your portfolio is still earning higher interest on the longer-term holdings. The alternative to directly purchasing bonds is to invest in a bond-based income fund where the daily management of the underlying assets is professionally handled.  Some of these funds provide investors with reasonable rates of interest, as well as the possibility of capital appreciation generated from regular bond valuations resulting in an attractive total return. 

 

 

Stocks

Low interest rates are good for stocks, at least in theory. Since companies are able to borrow money at lower rates in the market, they are able to fund more growth initiatives. If these investment programmes are successful, stock prices should rise due to increased earnings. In addition, low interest rates also cause stock-valuation models to produce higher stock values. In reality, it is much more difficult to determine how stocks will behave in a low interest-rate environment because there are many factors involved. One of these is that low interest rates coincide with poor economic conditions and low levels of investor confidence resulting in depressed (and volatile) share prices. 

 

What to avoid…

 

Long-term bonds

As previously mentioned, bond prices are inversely related to interest rates, so if interest rates increase, the price of the bond will decrease. Bonds with a longer term to maturity are riskier because interest rates will surely rise at some point in time within its duration. For example, if the coupon is set at six per cent and interest rates in the market eventually rise to eight per cent, the interest rate on the bond will be well below what an investor could get from an alternative investment. Therefore, the demand for the bond will decrease, driving the price of your bond downward on the secondary market. This will result in a paper loss in the overall value of your portfolio and a real loss should you need to liquidate your bond. 

 

 

Long-term fixed deposits

While longer-term fixed deposits may attract marginally higher rates than short-term fixed deposits, this may not be the most efficient use of capital in a low interest-rate environment. When interest rates are on the upswing, you will want to break this deposit to take advantage of higher yielding instruments on the market. This will undoubtedly attract a break fee. In addition, long-term fixed deposits do not allow for any sort of capital appreciation, so factoring in inflation, real returns are likely to be negative. 

 

 

The bottom line…

 

Whether your goal is a comfortable retirement, funding your children’s university education, or buying a house, your savings and investment activity is a means to those ends.  Of course, you should not just load your portfolio with securities (however well-chosen) and forget all about them. Successful investing involves regular monitoring and review. Pay particular attention to key economic variables such as interest rates, asset prices, and currency exchange rates and how they impact your portfolio to determine when and how to rebalance.  Have a disciplined plan and follow it carefully. This way, irrespective of the prevailing economic climate, you can still put the odds in your favour and optimise the returns on your investment dollars. 

 

Abbey Mohammed is an investment adviser at ANSA Merchant Bank Ltd