How interest rate hikes negatively affect investments

Interest rate hikes negatively impact investments, Glen sheds light on the complex dynamics at play in South Africa's financial landscape.

Glen Wattrus CFP®

Glen Wattrus CFP®

Private Wealth Manager

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How interest rate hikes negatively affect investments

As financial advisors, we are often called upon by anxious investors to explain why, when interest rates are rising, often for extended periods of time, the value of their income-generating unit trusts do not show a correlating appreciation in value. These unit trusts include income funds as well as property unit trusts (REITs).  

Regarding the latter type of unit trusts, it is obvious that, where properties are geared by way of mortgage loans, cost of capital will negate capital values to a certain extent. Think about it this way, if you buy a second home financed by a mortgage and rent it out to tenants, a rise in interest rates will impact on the net return you will get from the rent received from the tenants.

With income producing unit trusts in South Africa, the explanation is slightly more complex. As inflation rises, the only instrument at the Reserve Bank’s disposal is to hike interest rates in a bid to reign in inflation and cool off spending in the broader economy. That is all well and good for people with large asset reserves, but the pinch is felt almost exclusively by those who can ill-afford such hikes. The rate hikes have a knock-on effect across the economy in a negative sense as liquidity is drained from the pockets of people who owe large amounts of debt. One must also bear in mind that the Reserve Bank also has to raise interest rates to protect our currency. As Reserve Banks around the world raise rates, so South Africa becomes less attractive to foreign investors seeking reasonable returns from relatively risk-free assets such as government bonds. It must be stated that no investment is entirely risk-free but generally bonds will be more risk-averse than equities over sustained periods. By raising rates, the Reserve Bank attempts to combat the flow of foreign capital out of South Africa by making it more attractive to foreigners to remain invested.

Asset managers must also evaluate whether to remain invested in bonds or nibble at the tasty returns offered by shorter dated fixed deposits held with banking institutions. If the return from fixed deposits over a reasonable period exceeds that of holding a bond where the coupon remains the same to maturity, the likelihood is that the fund manager will sell off a portion of his bond holdings in favour of these shorter dated holdings. It doesn’t take an economist to see that when there is a glut of anything on the market, be it oranges, apples or whatever commodity, the price of that thing will drop. In the same way, the price that a new investor would be willing to pay for that bond drops, resulting in a negative impact on the capital value of the unit trust holding. By paying a lower price for the certainty of the coupon (interest paid at usually 6-month intervals), the new investor, in effect, gains a higher rate of interest, referred to as the spiking of the yield.

Without saying too much regarding our foreign policy, the incumbents cozying up to Russia and China and incidents such as the Lady Russia arms debacle also leads to foreign investors viewing our country, and consequently our government bonds, in a rather dim light and leads to a selling off of our bonds. Not only does this serve to weaken our currency with the flight of capital to perceived safer jurisdictions, but it drains supposedly “sticky” money out of our country for a long time. Through these actions, a glut of bonds will result, dropping the price, and thus impacting on the value of an income-producing unit trust. Last year foreign ownership of bonds was 26%, down this year to 24% (of R850 billion). When one considers that in 2018 foreigners owned 43% of about R750 billion, it gives an indication of how we as a country have regressed in the eyes of foreign investors.

There is, however, a measure of good news in that for every seller there must be a buyer, often the asset manager once again who can buy bonds back at a later stage for a better yield, due to the suppressed price.

This article explains, in some part, the capital value movement on interest generating assets but space does not allow for a wider discussion Perhaps in a later article, we'll have the space to explore this topic further.

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