It’s no surprise that we are in the midst of a rising rate cycle. The combination of continued Government spending (Federal and the States) has bought about the situation where the economy no longer has the capacity to meet demand. Increased demand brings about increasing prices and inflation. There are two ways of dealing with this: fiscal spending – governments reduce spending or increase costs or tax. Being politicians, there is no appetite for this. So, if fiscal policy won’t accommodate this, then it falls to the blunt tool of the Reserve Bank to deal with. They have two tools at their disposal – reduction in money supply (a complex process rarely uses) or raising interest rates which is what they have signalled they will do.
In today’s article, we examine the effect of rising interest rates on investment portfolios and what it means.
What the market has already priced in matters most. The rise is widely expected, and much of the adjustment in bond yields, share prices and the Australian dollar has already occurred in the weeks beforehand. The bigger moves on the day tend to come from surprises: a larger or smaller rise than expected, or a shift in the RBA’s guidance about future rates.
Cash and term deposits are the clearest beneficiaries. New deposits and at-call accounts should earn more, although banks don’t always pass rises through fully or immediately to savers. Those babies’ boomers with monies invested in cash will be short-term winners.
Fixed income is mixed. Existing fixed-rate bonds fall in value when yields rise, and the longer the duration of the bond, then the bigger the fall. The offset is that these bonds are receiving greater income or what is known as yield. Future income and reinvestment will then occur at higher yields. Much of what we hold in our portfolios are” floating rate notes” given the rise of interest rates has been expected, so they tend to hold value better.
Australian shares typically face valuation pressure, because higher rates reduce the present value of future earnings and raise borrowing costs for companies. Growth and technology stocks, whose value depends heavily on earnings far into the future, are usually hit harder. Banks are more nuanced: margins can improve, but higher rates can also increase loan defaults and slow credit growth. Consumer discretionary stocks can suffer as household budgets tighten. Given the Australian share market is dominated by banks, discretionary stocks and mining stocks, we see a very mixed result for Australian shares in the year ahead. The combination of recent tax changes and now rising interest rates should impact Australian shares adversely.
Rate-sensitive “Property Trusts” such as A-REITs, infrastructure and utilities often underperform, since their appeal rests on steady income that looks relatively less attractive as cash and bond yields rise, and many carry significant debt.
International investments can be affected through the currency. A rise may strengthen the Australian dollar, which reduces returns on unhedged international holdings when converted back to AUD. The impact on international investments will be limited.
Borrowing and gearing is where clients may feel it most directly. Margin loans, investment property loans, and debt held within an SMSF limited recourse borrowing arrangement become more expensive, which can affect cash flow. On the positive side, rising rates mean new builds are discouraged as the increased borrowing costs passed on by private credit providers mean it will be difficult for new developments to add up. This means with less stock on the market; existing properties should become more valuable. That depends on borrowing capacity which I discuss next.
Extra cost per month on a typical $500,000 loan, per a 0.25% rise
For an interest-only loan the answer is the same whatever the starting rate: $500,000 × 0.25% ÷ 12 = about $104 extra per month (about $1,250 a year).
For a principal and interest (P&I) loan over 30 years, the increase is smaller, because part of each repayment is principal that doesn’t change. The figures below use illustrative starting rates, not current market rates:
So as a rule of thumb, each 0.25% adds roughly $80 a month on a 30-year P&I loan and about $104 a month interest-only, per $500,000. It scales in proportion, so a $1 million loan costs roughly double.
Effect on borrowing capacity
Banks don’t assess affordability at the actual rate. APRA requires them to test serviceability at a buffer above the loan rate, which is currently 3 percentage points. This means if the rate is 6%, then potential borrowers will be assessed at 9%.
A borrower who qualified for $500,000 would qualify for about $489,000 after a 0.25% rise. That is roughly $11,000 less, or about 2 to 2.3% of borrowing capacity per 0.25% rise. Successive rises compound, so four rises (1%) would reduce capacity by around 9%, which would be significant.
On average, borrowing applications have declined by roughly 20% compared to 12 months ago. Secondly, investors in property have fled the market in the light of recent tax changes. A rising interest rate scenario will make it more difficult for owner occupiers to enter the market.
What this means to you
Rising rates create both opportunities and challenges. Investors with cash may benefit from higher interest, and reinvesting fixed income at higher yields can lift future returns. Borrowers, and some parts of the share and property markets, are likely to feel more pressure.
A single rate decision is rarely a reason to change a long-term investment strategy. Diversified portfolios are designed to hold a range of assets that respond differently to changing conditions. Reacting to short-term market moves can mean locking in losses.