With suggestions that U.S. Federal Reserve rates may rise 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 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 installments on your loans.
In Singapore, most people have to take housing loans to afford their homes. Housing loan interest rates have been very low since 2009, and are currently at about 2% per annum. For someone who is borrowing $500,000 for 30 years, this means his monthly loan installment would cost about $1,848. If interest rates were to go up by 1%, his monthly loan installment 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 takes a car loan of $50,000 for five years at 2.5%p.a., his monthly installment is $938 a month. If interest rates rise by 1%, his monthly installment rises to $979 a month. The difference is $41 a month, or $492 a year. So for someone who has a housing and car loan as illustrated, his yearly expense would increase by $3,612 simply due to a 1% rise in interest rates.
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 take a 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 installments 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 installments 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 appear more attractive and stocks relatively less so, due to the different risks involved, which 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 telecommunications, as investors weigh the risks of holding their stocks for dividends against bonds which do not pose the same risk to their capital. Higher interest rates can also affect company profits as they have to pay their creditors higher rates to fund their businesses, resulting in them having lesser funds to reinvest in the business, leading to slower growth and hence lower returns in their stock prices. Higher borrowing costs make leveraging even less attractive and a more risky 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 bond price would have fallen which may make selling the bond an unattractive option.
For investors who bought 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 those who have very high IQs, notably 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 the higher interest rates. 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 attaining 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 create 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 are still standing when markets go awry are usually those who have a long-term investment perspective and a well-diversified investment portfolio. Oh, and they sleep better too.
This is an original article written by Sean Cheng, Portfolio Manager at Providend, Singapore’s Fee-only Retirement Financial Adviser.