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24-10-2011, 04:53 AM
Business Times - 24 Oct 2011
The link between interest rates and investments
With investing, there are any number of factors which influence your portfolio's value but lie entirely outside of your sphere of influence; interest rates are one such variable, reports TEH SHI NING
WITH investing, there are any number of factors which influence your portfolio's value but lie entirely outside of your sphere of influence. Interest rates are one such variable.
Though they - along with inflation, market volatility, natural disasters, economic downturns, policy decisions and others - are out of your control, it helps to understand what they are and how they will affect your investments.
Today's piece looks broadly at what drives changes in interest rates in Singapore, as well as how interest rate changes affect different types of investments.
Singapore's interest rates are market determined. This is unlike many economies, whose interest rates are a key monetary policy tool set by central banks. Given Singapore's unusual degree of openness to trade and capital flows, the Monetary Authority of Singapore (MAS) chooses to effect monetary policy via a trade-weighted exchange rate instead.
What then affects interest rates here? The domestic interbank reference rate here (Singapore's interbank offered rate or Sibor), has been shown to mirror changes in US interest rates. It is also significantly impacted by changes in market expectations of future movements in the exchange rate.
In a season of historically low global interest rates, Singapore interest rates too, have been low for some time now. And this looks set to continue for awhile - the major economies continue to keep monetary policy loose as the recovery from the 2008/09 recession has been weak and uncertainty over the global economic environment rises. The US Federal Reserve for instance, has pledged to keep its funds rate near zero per cent until at least the middle of 2013.
Just over a week ago, the MAS also eased monetary policy for the first time in two years, allowing for gradual appreciation of the Singapore dollar relative to its trading partners' currencies, but at a slower place.
It was a decision which followed a surprise interest rate cut by Indonesia's central bank, showing regional authorities' shifting from concern over inflation to that of supporting their economies' growth.
Impact on investments
The most basic asset class - cash - naturally does not benefit from low interest rates, as savings in your bank deposit accounts earn less interest each month.
If fixed income investments such as government or corporate bonds are already a component of your portfolio, then falling interest rates could be good news.
Nanyang Business School's assistant professor of finance Stephen Dimmock says, 'Fixed income investments have an inverse relation with interest rates. This means that when interest rates fall, bond prices rise. Conversely, when interest rates rise, bond prices fall.'
The bond issued earlier rises in value because it pays the investor more interest than the bond issued at the new and lower interest rate.
What this does mean, is that the new investor ought to avoid investing in long-term bonds at the moment, since there is little room for interest rates to go anywhere but up, upon which long-term bond prices will fall.
Short-term bonds may be a better option, despite the typically lower interest rate they pay, as they tend to be less sensitive to changes in the market interest rate. Of course, if bond investors are able to hold the bond to maturity and regain the principal amount, then there is little worry over changes in the bond's price due to changes in the interest rate.
'Stocks usually perform well when real interest rates are low,' Dr Dimmock says. This is because when interest rates are low, the cost to companies of borrowing capital falls. This tends to mean that companies are able to invest in growth ventures, which if successful would boost profits and stock prices.
'However, low real interest rates usually occur during adverse economic times, and during these times, stocks can be especially volatile,' he adds. The stockmarket's roller-coaster ride of the past few months bear witness to that.
In such a low interest environment, dividend paying stocks are also favoured for generating a steady stream of dividend income to investors. Companies to look out for would include those whose businesses are relatively recession-resilient and not affected by dampening of consumer sentiment when stockmarkets plunge. These may be companies with a record of stable profits, in relation to which share prices are still modest, and ones which provide good dividend yields.
Agreeing that low interest rates tend to be positive for investments in stocks and real assets, Phoon Kok Fai, Associate Professor of Finance (Practice), SMU Lee Kong Chian School of Business too, cautions that these times usually coincide with other risks.
At the moment, for instance, he sees other risk concerns, such as 'systemic risk, where banks are unwilling to lend due to credit concerns'.
And, if monetary policy globally continues to be loose, bubbles may begin to form, 'resulting in monetary tightening, increase in interest rates and substantial decline in prices of bonds, stocks and real assets,' he says.
In this current low interest rate environment, Dr Phoon suggests that the young investor, while cognisant of the risks involved, should be investing in stocks and real assets, instead of leaving their cash in deposits.
'A more risky strategy, though inadvisable, is to use leverage in such an environment,' says Dr Phoon.
The link between interest rates and investments
With investing, there are any number of factors which influence your portfolio's value but lie entirely outside of your sphere of influence; interest rates are one such variable, reports TEH SHI NING
WITH investing, there are any number of factors which influence your portfolio's value but lie entirely outside of your sphere of influence. Interest rates are one such variable.
Though they - along with inflation, market volatility, natural disasters, economic downturns, policy decisions and others - are out of your control, it helps to understand what they are and how they will affect your investments.
Today's piece looks broadly at what drives changes in interest rates in Singapore, as well as how interest rate changes affect different types of investments.
Singapore's interest rates are market determined. This is unlike many economies, whose interest rates are a key monetary policy tool set by central banks. Given Singapore's unusual degree of openness to trade and capital flows, the Monetary Authority of Singapore (MAS) chooses to effect monetary policy via a trade-weighted exchange rate instead.
What then affects interest rates here? The domestic interbank reference rate here (Singapore's interbank offered rate or Sibor), has been shown to mirror changes in US interest rates. It is also significantly impacted by changes in market expectations of future movements in the exchange rate.
In a season of historically low global interest rates, Singapore interest rates too, have been low for some time now. And this looks set to continue for awhile - the major economies continue to keep monetary policy loose as the recovery from the 2008/09 recession has been weak and uncertainty over the global economic environment rises. The US Federal Reserve for instance, has pledged to keep its funds rate near zero per cent until at least the middle of 2013.
Just over a week ago, the MAS also eased monetary policy for the first time in two years, allowing for gradual appreciation of the Singapore dollar relative to its trading partners' currencies, but at a slower place.
It was a decision which followed a surprise interest rate cut by Indonesia's central bank, showing regional authorities' shifting from concern over inflation to that of supporting their economies' growth.
Impact on investments
The most basic asset class - cash - naturally does not benefit from low interest rates, as savings in your bank deposit accounts earn less interest each month.
If fixed income investments such as government or corporate bonds are already a component of your portfolio, then falling interest rates could be good news.
Nanyang Business School's assistant professor of finance Stephen Dimmock says, 'Fixed income investments have an inverse relation with interest rates. This means that when interest rates fall, bond prices rise. Conversely, when interest rates rise, bond prices fall.'
The bond issued earlier rises in value because it pays the investor more interest than the bond issued at the new and lower interest rate.
What this does mean, is that the new investor ought to avoid investing in long-term bonds at the moment, since there is little room for interest rates to go anywhere but up, upon which long-term bond prices will fall.
Short-term bonds may be a better option, despite the typically lower interest rate they pay, as they tend to be less sensitive to changes in the market interest rate. Of course, if bond investors are able to hold the bond to maturity and regain the principal amount, then there is little worry over changes in the bond's price due to changes in the interest rate.
'Stocks usually perform well when real interest rates are low,' Dr Dimmock says. This is because when interest rates are low, the cost to companies of borrowing capital falls. This tends to mean that companies are able to invest in growth ventures, which if successful would boost profits and stock prices.
'However, low real interest rates usually occur during adverse economic times, and during these times, stocks can be especially volatile,' he adds. The stockmarket's roller-coaster ride of the past few months bear witness to that.
In such a low interest environment, dividend paying stocks are also favoured for generating a steady stream of dividend income to investors. Companies to look out for would include those whose businesses are relatively recession-resilient and not affected by dampening of consumer sentiment when stockmarkets plunge. These may be companies with a record of stable profits, in relation to which share prices are still modest, and ones which provide good dividend yields.
Agreeing that low interest rates tend to be positive for investments in stocks and real assets, Phoon Kok Fai, Associate Professor of Finance (Practice), SMU Lee Kong Chian School of Business too, cautions that these times usually coincide with other risks.
At the moment, for instance, he sees other risk concerns, such as 'systemic risk, where banks are unwilling to lend due to credit concerns'.
And, if monetary policy globally continues to be loose, bubbles may begin to form, 'resulting in monetary tightening, increase in interest rates and substantial decline in prices of bonds, stocks and real assets,' he says.
In this current low interest rate environment, Dr Phoon suggests that the young investor, while cognisant of the risks involved, should be investing in stocks and real assets, instead of leaving their cash in deposits.
'A more risky strategy, though inadvisable, is to use leverage in such an environment,' says Dr Phoon.
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