As monetary authorities keep interest rates lower for longer, income-based investors are losing out.
Just over a year ago I wrote about negative yields after having been scratching my head about the concept for some time. My conclusion was that a negative yield wasn’t that uncommon. Gold, for example, had an effective negative yield due to storage and insurance expenses. But I did conclude that negative yields were ultimately nonsensical and would, surely, in time revert to normal.
I haven’t changed my mind on the first point, but the reverting to normal part has at best been delayed for many years. US Federal Reserve (Fed) chairman Jerome Powell has said the bank will be keeping rates at zero until at least 2023, while the Bank of England said in its latest rate announcement it is exploring negative interest rates.
This is because of the coronavirus pandemic, but it has got me thinking a lot about negative interest rates again. South Africa’s prime lending rate is not close to zero, but at 7% is at multi-decade lows, and our Monetary Policy Committee (MPC) has signalled that any increases would only be implemented by late 2021 at the earliest.
Staying local, a 7% prime rate has a lot of implications for investors.
Seeking better rates will most often push up the risk.
Sure, you may get offered an attractive 10% interest rate, but is it sustainable and will the provider honour the deposit agreement? Chasing higher rates will increase the risk, which is exactly what those looking for income do not want – and any rates much higher than prime should be viewed with deep scepticism.
Listed preference shares and government retail bonds are certainly an attractive option, with the latter currently offering 8% for five years, while quality preference shares are at about the same rate. OUTvest has an endowment paying a simple 10.7% rate if you’re in the top tax bracket and have exhausted your interest exemption, but here your investment is locked in for five years.
For investors, low interest rates make the stock market more attractive as, suddenly, a dividend yield of, say, 4% is not so bad compared with current bank rates for cash. This is especially the case if you consider that you also get the potential of capital appreciation.
Furthermore, a lot of investors who’d rather buy the relative safety of government debt, or put their money in the bank, are moving into the stock market as they seek returns for income.
Back when interest rates were first being slashed in 2008 and 2009, inflation was a concern, but inflation has disappeared worldwide – even as the US hit an unemployment rate below 4% at the beginning of the year. One would expect low unemployment to drive wages higher and hence spending and inflation. But inflation remains subdued and I’ll cover this in detail in a separate column.
But the real question is when will rates rise again and some sort of normality return? I suspect the Fed and our MPC are probably both wrong and we’ll see lower rates for longer, much longer.
This is especially the case after the Fed said it will use an average inflation rate rather than the 2% line in the sand – giving it a lot more wiggle room for lower interest rates for longer. If inflation is not rearing its head any time soon, why raise interest rates? Why not keep the cost of borrowing money low, especially as it should support growth?
For income investors this has serious implications. Rather than just holding on and hoping, one should have a hard look at restructuring both the investments and also the expenses side of this equation.