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The impact of interest rate on investments

There is much speculation on whether the South African Reserve Bank will cut the repo rate later in the year. As a trustee, it’s important to understand the effect of an interest rate cut or rise on your retirement fund’s assets.

At the time this article was published the government’s interest rate, also called the repo rate, was 8,25 %. This is the rate at which private (sector) banks borrow rands from the South African Reserve Bank. You can find the updated repo rate here:  A country’s repo rate is a benchmark for short-term interest rates in the economy. When you hear and see news reports about interest rates going up or down they usually refer to the country’s repo rate.

The impact on a retirement fund’s assets will depend on which assets the fund is invested in, the economic environment, and the mandate of the fund. There are typically five asset classes: debt instruments, cash, equities (shares), property and commodities, and alternative assets. (Click here for a recap on asset classes.)

What is the interest rate?

An interest rate has a good and a bad side depending on whether your retirement fund or the companies you invest in are borrowing or lending money. In simple terms, an interest rate is the cost of borrowing money or the return on investment for lending money.

Let’s look at how the interest rate affects a retirement fund’s assets.

1 Debt instruments

Retirement funds can invest in debt. This “debt” usually takes the form of government bonds where the retirement fund lends money to the government for infrastructure projects, for example, for a fixed term. The fund receives regular interest payments on the bond. These bonds can also be bought or sold as they are tradeable instruments.

Bond prices and interest rates have an inverse relationship. When interest rates go up, the prices of existing (older) bonds fall, and when interest rates go down, existing bonds’ prices rise. This is because older bonds with higher interest rates become more attractive in comparison to new bonds issued at lower rates. If the retirement fund holds bonds, the value of these bonds in the portfolio might increase. (The relationship between newly issued bonds and interest rates is more complex. We will deal with that at a later stage.)

Most bonds are fixed-rate bonds, which means the monthly interest is set at a specific amount; therefore, movements in the interest rates would not impact the monthly income the retirement fund receives.

Debt instruments = Bonds = Fixed-income securities

2 Equity (Shares)

In general, equity and interest rates have an inverse relationship; however, it is not as direct as with debt instruments. If the Reserve Bank lowers the interest rate the intent is usually to stimulate the economy. Companies may find it cheaper to borrow money, which can boost production, research and development, and corporate profits. As a result, share prices might rise, positively impacting the equity portion of the retirement fund. The opposite is also true; a high interest rate makes it more expensive to borrow, which subdues economic activity. Companies might struggle to repay loans and be unable to launch new products and campaigns. All these factors could lead to a decrease in the share price, which in turn would harm large shareholders such as retirement funds.

3 Real assets

The value of real assets and interest rates have an inverse relationship. Retirement funds can invest in real assets by acquiring physical property or investing in Real Estate Investment Trusts (REITs).

A rise in interest rate makes it more expensive to repay property loans and to buy new properties. This could lead to a decline in the demand in the property market, which in turn would cause a decline in the value of properties. Both these scenarios could harm the real estate assets of your retirement fund.

However, low interest rates stimulate activity in the real estate market as affordable loans are easier to come by. This boosts demand for property and has a positive impact on the asset.

4 Commodities

Although it is complicated, put simply, commodities have the same inverse relationship with interest rates as real assets and bonds. This is mainly because the interest rate influences the cost of storing commodities. In a low interest rate environment, when it’s cheap to store commodities, businesses tend to stock up, which pushes the price higher. A retirement fund’s investment in commodities might increase in value.

5 Cash

If the retirement fund holds a significant amount of cash or cash equivalents, lower interest rates could result in reduced income from these investments. Money-market funds, for example, often yield less when interest rates are low.

6 Alternative investments

These are financial assets that do not fall under the traditional asset classes. They include private equity, hedge funds, and infrastructure. As with real estate and bonds, alternative investments tend to decline as interest rates rise. Alternative investments usually carry a lot of risk and private equity firms need large amounts of capital from various investors to get start-ups to the next level. With the rise in the cost of capital, it becomes increasingly challenging to raise more funding. Beyond constraining potential investors, high interest rates also tend to increase the cost of repaying existing debt. This situation could bankrupt these firms, leading to a negative impact on the alternative asset portion of the retirement fund’s portfolio.

The effect of varying interest rates again illustrates the importance of not having all your eggs in one basket. A retirement fund with a well-diversified portfolio with a mix of asset classes will be better positioned to weather changes in interest rates.