By Peet Serfontein
What are interest rates?
Interest rates refer to the cost of borrowing money or the return you earn on your savings. The SARB determines the benchmark repurchase rate (repo rate), which directly affects the interest rates that commercial banks, like FNB, charge for loans and offer for deposits.
When the SARB raises interest rates, borrowing becomes more expensive, and saving becomes more attractive. When rates are lowered, borrowing costs decrease, encouraging spending and investment, while the returns on savings diminish.
How interest rates affect different asset classes
Cash investments
Cash investments include savings accounts, fixed deposits, and money market funds that provide regular interest payments and are considered lower risk.
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Higher interest rates: Earnings on fixed-income investments rise with interest rates, making them more attractive to conservative investors seeking stable returns. This can lead to increased inflows into savings accounts and fixed deposits.
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Lower interest rates: Lower earnings reduce the attractiveness of fixed-income investments, prompting investors to look for higher returns in other asset classes. This can lead to outflows from these investments.
Bonds
Bonds are debt securities issued by governments or corporations. They pay periodic interest and return the principal at maturity
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Higher interest rates: Bond prices typically fall when interest rates rise as new bonds are issued with higher yields, making older bonds less attractive. However, new investors benefit from higher yields on new bonds.
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Lower interest rates: Existing bonds with higher interest rates become more valuable when rates drop. New bonds will have lower yields, prompting some investors to seek higher returns elsewhere.
Bond duration is a measure of how sensitive a bond's price is to changes in interest rates. Bonds with longer durations are more sensitive to interest rate changes, meaning their prices will fluctuate more when rates change. Short-duration bonds are less affected by interest rate changes and provide more stability in a rising rate environment.
Equities
Equities, or shares, represent ownership in a company and a claim on part of the company's profits. Interest rate changes can significantly impact equity markets.
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Higher interest rates: When rates rise, companies face higher borrowing costs, which can reduce their profits, especially if they rely heavily on debt. This often leads to lower share prices. Investors might also shift towards fixed-income securities, which are seen as safer investments in a high-interest environment, potentially causing a sell-off in equities.
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Lower interest rates: Lower borrowing costs can boost a company's profits and encourage business expansion, leading to higher share prices. Lower interest rates also make equities more attractive compared to bonds and other fixed-income investments, as they offer higher potential returns.
Interest rate changes can affect different sectors within the equity market in various ways. For instance, consumer stocks struggle during periods of higher interest rates as consumer spending comes under strain. Conversely, banks often benefit from higher interest rates because they can charge more for loans although over time it could lead to an increase in loan defaults, negatively impacting profits.
Real estate
Real estate includes residential, commercial, and industrial properties. Interest rates impact real estate through mortgage rates and the cost of financing property purchases.
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Higher interest rates: Increased mortgage rates make property purchases more expensive, reducing demand and potentially lowering property values and rental yields. Higher financing costs can also slow down new projects and reduce returns on existing investments.
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Lower interest rates: Lower mortgage costs make buying property more affordable, increasing demand and driving up property values and rental income. Lower financing costs encourage property development and investment, leading to potentially higher returns.
These impacts are true for both the direct property market and in the case of listed real estate investment trusts (REITs).
Strategic considerations for investors
In a dynamic interest rate environment, you can adopt several strategies to optimise your portfolio:
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Diversification: Spread your investments across different asset classes, sectors, and geographic regions to manage risk and reduce the impact of interest rate changes on your portfolio.
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Duration management: For bond investors, managing the duration of your bond holdings is crucial. Shorter-duration bonds are less sensitive to interest rate changes, while longer-duration bonds offer higher yields but come with greater risk.
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Income generation: In a low-interest-rate environment, seek higher-yielding assets like dividend-paying equities, REITs, or high-yield bonds to generate income.
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Risk assessment: Understand the risk profile of each asset class and how it aligns with your risk tolerance and investment goals. Equities offer higher returns but come with higher volatility, while fixed-income investments provide stability but lower returns.
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Market analysis: Stay informed about economic indicators, SARB's monetary policy decisions, and market trends to anticipate interest rate changes and adjust your strategies accordingly.
