With interest rates close to zero, should you still invest in fixed interest?

In the past, portfolio theory was fairly simple. To work out how much you should allocate to growth-based assets, you simply used the following formula:

100 – your age

The result was the percentage you should have in growth-based assets, and the balance would go into fixed interest/defensive assets. So if you were 30, you’d have 70% growth-based assets, and 30% fixed interest/defensive assets. Simple!

These days things are a lot more sophisticated, with detailed behavioural finance profiling based on an investor’s unique attitude to money and investing, to maximise and optimise their asset allocations.

Most investors today are likely to have some exposure to fixed interest investments depending on their individual mix. But what happens when interest rates fall close to zero? In this case a fixed asset class is simply not going to provide a return, so in the longer term should they drop this exposure from their portfolio?

If we think about economics in simple terms, typically a central bank will increase interest rates when times are good, and drop them when times are bad or there are economic concerns that warrant movement.

So, what is happening right now? Well, as the RBA is continuing to drop the rate, it may be wise to be a little cautious: they could be expecting some drama in years to come. Then again, these cautionary measures might serve to nullify this potential drama.

With interest rates at ultra-low levels, investors might be tempted to simply move funds out of the fixed interest or defensive asset classes, and chase growth or higher yields in other areas of the market.

At the time of writing this article, we can see this happening right now: term deposit investors are dumping their safe investments, opening stockbroking accounts and flocking towards the household names that have historically yielded high dividends.

This is why we are currently seeing a ‘pop’ in prices in this high-yield space, as capital transitions towards these asset classes.

We think this is might end in tears.

At some point, we suspect this spike will normalise, and then reality will set in. Investors who have bought into this area will likely see a share price adjustments reversion, which will likely offset any high dividends they might have received.

One of the biggest risks you face as an investor is being tempted into moving into a higher category of risk to chase higher returns, during a period where you might be needing to be more conservative.

On the bright side, at the moment there are a few areas of the market that still provide a reasonable return on fixed interest and defensive assets, but I suspect this window will close within two years’ time as the market catches on.

The reality is, if you’re holding onto that term deposit thinking things will get better, looking at the 10-year bond yield, which is currently paying 1.28% p.a., unfortunately it’s pricing in only one interest rate rise within the next 10 years.

As we all know, a small piece of economic news can change things dramatically, but at this stage the market is not predicting higher interest rates anytime soon.

Like most things to do with finance, this is a fairly complex area to navigate. Deciding exactly where to head to maintain your asset allocation weighting and keep the protection levels at a suitable level can be tricky. And although everyone’s situation is different the portfolio theory, which is based on hundreds of years of positive interest rates, will be challenged. So we do need to be thinking about these issues today – before any opportunities are vaporised.

So before you jump in and try to work out for yourself which way to turn to capture the moment, we would recommend that you speak with a suitably qualified, practising financial planner and of course, I recommend AJ Financial Planning.

What is the impact of negative interest rates?

Run the Red; Run the Risk – How negative interest rates turn economies on their heads.

If you have a home loan or a term deposit, then it is likely that you also have some level of curiosity around what is going on with interest rates.

Each month, the Reserve Bank of Australia (RBA) meets and sets the interest rate. Currently, it’s set at 2%. If the RBA decides to increase interest rates, it is likely your mortgage will also increase, although on the upside, so will term deposit rates; equally, if the RBA drops interest rates, your mortgage repayments will drop—but so too will interest earned from your term deposits.

Like the RBA, the central reserve banks in other countries use interest rates to stimulate or slow their economies. In simple terms, they drop interest rates to stimulate economic activity when things get too ‘hot’, and they increase interest rates to cool them down. Oftentimes, though, the reaction times are a little too slow, which causes things to go off the rails, resulting in the boom-bust cycle continuing ad nauseum.

Now, consider what would happen here if RBA interest rates became negative. What would be the impact on cash in the bank, lending, and other areas of the economy?

Today, Japan, Sweden, Switzerland, and the Euro zone all have negative interest rates (to varying degrees).

If you placed your money into a bank account in Europe right now, it’s highly likely you would be actually charged interest for putting money in the bank. That’s right—you would not be earning interest; instead, you would be charged a fee for depositing the money! In the long term, of course, this really hurts savers and retirees.

Conversely, in some cases if you have a loan with a bank in Europe, the bank will pay your mortgage for having this debt drawn down. Other loans are simply dished out at a very low interest rate, such as 1–2% p.a. Naturally, this encourages people to take on debt at levels far greater than when interest rates are at normal levels.

You can see that very odd things start to happen in the long-term as this topsy-turvy situation plays out.

Other areas of the economy also become distorted. If there is a trade surplus position like Japan, which means they export more than they import, then negative interest rates could end up pushing the currency up against, say, the US dollar.

On the other hand, if there is a trade deficit, the currency can depreciate—like the British pound did against the US dollar. This all has to do with the need for funding and attracting overseas investment to fund the shortfall. In Australia, if we ever went negative, we would almost certainly suffer a similar fate to the UK.

The hope is that in the long term, these economies will normalise and interest rates will return to a more normal level. However, if the market continues to price in negative interest rates for Japan and Switzerland for at least the next 10 years, this phenomenon might be around longer than we think.

So, if you see some strange things happening abroad, remember it might relate to the negative interest rate environments these countries are currently enduring, and bear in mind that one day, their interest rates will likely normalise.

Please also remember that before embarking on any investment decision, you should always seek professional guidance from a licensed financial planner. Of course, I recommend AJ Financial Planning.

Interest Rates…Should I borrow more when they are high or low?

In 1976 the RBA (Reserve Bank of Australia) cash rate was around 12.85% and the average home loan back then was around 15.35% to 17% p.a.  Today some 38 years on, things are very different with the RBA cash rate at 2.5% and the average home loan is around 5%. Now in the past 10 years or so the RBA cash rate has not been as extreme. In reality they have floated between 7.25% and as low as just 2.5% more recently. The question I often here is “Should I borrow more when the interest rates are lower?”  You could buy things like a bigger home or an investment property, or use leverage for a business or an investment portfolio?  Another other option could be to focus more on paying down debt when interest rates are very low.  You can pay down debt a lot faster as the interest rate is not as high. Today, interest rates are incredibly low based on historical measures.  Regularly I see ads for 0% finance on a new car being purchased.  Credit card companies are offering interest free periods and to purchase an investment properties (depending on the yield as sometimes there can be variance) can be close to cash flow neutral if the deposit is large enough. Alternatively, it could be a time to think about renovating the home using debt, or buying a bigger house and borrow more as interest rates are so low.  It can be a very tempting time to go on a credit binge! So the questions becomes “Should I take advantage of all this cheap credit?”  The answer however like most questions in finance, is a little more challenging. In reality sometimes you want to be acting counter cyclical with the approach you take.  This idea is more common place with investing which goes something like this….. when everybody is running for the hills and not wanting to buy shares…you should be buying shares (assuming the asset is close to the bottom).  When everybody is going crazy for shares and there is a bubble you should be possibly thinking about selling. So how do you apply this idea to the interest rate questions?  Well most crashes generally are based on cheap credit, the lead up to the GFC people were using their homes and the equity in their properties as an ATM machine to buy stuff.  When the cheap credit stopped and the equity stalled everything, or in simplistic terms, it literally ground to a hault including consumer spending. So the answer to the above question comes back to the 2 following questions you might ask?

  1. What am I doing with the credit and what am I trying to buy?  If I apply a counter cyclical methodology I should really be asking myself is everybody running for the hills or jumping in thinking this is too good to be true?
  1. Can I afford this debt if interest rates rise on this debt to 8% or higher?  Today a 1% increase in interest rates would put 25% of the mortgaged population in mortgage stress, you want to make sure you are not in this sinking boat.

Like all difficult decisions it is important to do some complex financial modelling to work out which is the best way to go, and this is where we can help!  We can put together a blue print path for you, crunch all the numbers, and work out the best way for you to go. So if you would like to seek qualified Financial Planning assistance and we would recommend speaking with our team at AJ Financial Planning.