With suggestions that U.S. Federal Reserve may raise their interest rate benchmark in 2017 due to a recovery in the U.S. economy as well as an anticipated increase in fiscal spending under President Trump’s administration, Singapore’s interest rates may follow suit, as they largely move in tandem with U.S. Federal Reserve rates. What does this mean for the man on the street? Well, most of the impact will depend on whether you are a net borrower or net lender. If you are highly leveraged, it may be time to reconsider your strategy.
If you are a borrower, be prepared to pay higher monthly instalments on your loans.
In Singapore, most people must take a housing loan to afford their homes. Adjustable-rate mortgage interest rates have been very low since 2009 due to depressed reference rates and are currently at about 2% per annum. If someone were to borrow $500,000 with a 30-year payment term, his monthly loan instalment would cost about $1,848. If interest rates were to go up by 1%, his monthly loan instalment would rise to $2,108. That’s a difference of $260 a month, or $3,120 a year.
The other loan that many Singaporeans take is a car loan. If someone were to buy a car with a loan of $50,000 to be repaid over 5 years at 2.5% per annum, his monthly instalment would be $938 a month. If interest rates rise by 1%, his monthly instalment would rise to $979 a month. The difference is $41 a month, or $492 a year.
So, for someone who has both a housing loan and a car loan, a 1% rise in interest rates are likely to increase his yearly loan payments by about $3,612.
If you are a lender, then rising interest rates is generally good news.
Retirees, who are usually lenders, will benefit from this. Your fixed deposit rates, for example, should go up, so you get a better return on your cash. If you buy a bond, you are effectively lending money to the issuer of the bond, and rising interest rates will mean that you will be able to obtain a higher interest coupon when you look to buy one. If interest rates continue to rise after you’ve bought the bond, the value of your bond may go down, but as long as you hold the bond to maturity and the issuer does not default, then you will get your initial capital back having collected the interest coupons along the way.
What if you are someone who borrows to invest?
So far it has been relatively straightforward, but this is where it gets dicey. For investors who employ leverage – in other words, they borrow money to invest in assets such as properties, stocks, bonds and other financial instruments to try to amplify their investment returns – it is very important for them to understand how interest rate movements can affect the value of their assets because every movement in the asset price is magnified by their use of leverage. In the worst-case scenario, if the asset price falls by too much they may be forced by the lender to sell the asset and take huge losses.
Let’s look at property. From 2009 to 2013, property prices in Singapore rose significantly as the low-interest rate environment left many investors hungry for a better return on their cash. The idea was to borrow cheap, rent out the property to pay off the loan instalments and possibly make some extra cash while waiting for property prices to increase. However, due to the government’s tightening measures, prices have fallen since the end of 2013, with rental yields decreasing alongside them. With interest rates rising, demand is likely to fall further as higher monthly instalments make investing in property look even less appealing, even as supply continues to increase.
Those who have already bought properties with bank loans have been affected by rising monthly instalments on one hand, and falling rental income on the other, thus getting squeezed uncomfortably in the middle. Some luxury property investors have already taken the hit, with 15 out of 21 resale transactions in Sentosa Cove being sold at losses in 2016, and if interest rates continue to rise – assuming the government does not ease its tightening measures – property investors are likely to be facing further pain ahead.
For stock investors, it is important to note that rising interest rates make assets such as bonds more attractive and can lead to lower stock prices. This is especially so for stocks which have been traditionally more yield plays due to their high dividends, such as REITs and telecommunication stocks, as investors weigh the risks of holding stocks for dividends against bonds which do not pose the same risk to their capital. Higher interest rates can also affect companies’ profits as they must pay their creditors higher rates to fund their businesses, leaving them with less cash to reinvest, slowing growth and weakening shareholders’ returns. Higher borrowing costs make leveraging even less attractive and a riskier proposition, as the downside risks get larger and the upside gets more challenging.
Bonds which are already trading in the secondary market will see their prices fall as interest rates rise because newer issues will be traded at higher interest rates for similar tenures, rendering the older ones unattractive. Hence a bond investor who invested into a long-dated bond that pays 3%p.a., but leveraged by borrowing money from the bank to buy more of the bond, will find that he needs to pay higher leveraging costs, and yet if he wishes to sell the bond, the lowered bond price may make selling the bond an unattractive option.
For investors who hold high-yield bonds, the margin between the yield and cost of borrowing may be wider, but there may be other concerns. High yield bond issuers usually have weaker financials (hence the need to issue bonds at a higher yield), and if interest rates climb, their increased business costs raise the chances of a default. Add a slow-growth economic environment into the picture and it does not look good for high yield bond issuers and their investors. For those who are leveraged, the risks are considerably higher.
What should one then do in a rising interest rate environment?
Firstly, if it is possible, borrow less. This is obviously more pertinent for those who are actively employing the use of leverage in their investing. As indicated previously, the use of leverage becomes more unattractive when interest rates go up. If you have a wide margin between your investment returns and your cost of borrowing, then it may still appear to make sense to leverage, but always use leverage with caution. Excessive use of leverage has been the downfall of many investors, even industry professionals such as the managers of the renowned-turned-infamous hedge fund LTCM. Our advice would be not to use leverage at all.
Secondly, spend less and save more. Not only will this provide you with the funds to cover any rise in your loan payments; the more savings you have, the more you will able to lend in the form of fixed deposits and bonds and benefit from the higher interest rate environment. Or you could just use those savings to make early repayments in your loans so that you do not have to pay as much in higher interest payments. Moreover, we expect that returns on investments are likely to be lower in the next ten years than they have been for the past few decades, so saving is going to be even more important in growing your retirement nest egg.
Lastly, be prepared for the unexpected. In the financial markets, anything can happen, and it is usually the unexpected events (not necessarily rising interest rates) that can wreak the most havoc to our portfolios. As Warren Buffett said, “only when the tide goes out do you discover who has been swimming naked.” Those who have a long-term investment perspective and a well-diversified investment portfolio are usually the ones still standing when markets go awry. Oh, and they sleep better too.
This is an original article written by Sean Cheng, Portfolio Manager at Providend, Singapore’s Fee-only Wealth Advisory Firm.
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