THE SILVER LINING OF HIGHER INTEREST RATES
Mark Lister, 3 February 2023
Savers have had a tough time in recent years, with low interest rates making it difficult to generate reasonable income from an investment portfolio.
Today, things have changed and conservative investors no longer face a dearth of opportunities.
Cash, term deposits and fixed income have all provided meagre returns for the last several years.
The near-zero interest rates of 2020 and 2021, which were part of the COVID-19 response, saw already-scant returns become even worse.
Just 18 months ago, the six-month term deposit rate was just 0.8 per cent. According to Reserve Bank data going back to 1965, that’s the lowest in history.
This forced people to step outside their comfort zone and put capital originally destined for lower risk assets into housing and shares, among other things.
For the most part, that’s worked out okay.
In the five years to the end of 2021, New Zealand house prices increased 65.5 per cent and New Zealand shares by 89.2 per cent (or 10.6 and 13.6 per cent per annum, respectively).
Those returns are much better than anyone would’ve achieved from more conservative assets.
However, risk and return go hand in hand, and property and shares have come back down to earth more recently.
Since the respective peaks in 2021, house prices are down 15.2 per cent while shares have fallen 11.2 per cent.
For those who invested some time back, these declines won’t be a significant concern.
Higher highs and lower lows are par for the course when investing in higher-returning growth assets, but not everyone is comfortable with these ups and downs.
Many New Zealanders have a more conservative mindset. They’re looking for steady, reliable income, and a low level of volatility that will allow them to sleep at night.
For these investors, the drought is over and there is a plethora of opportunities on offer.
The six-month term deposit rate has increased to 4.5 per cent.
For the first time since 2008, that’s higher than the dividend yield for the sharemarket, which is about 4.0 per cent at present (including imputation credits).
It’s also well above the typical rental yield available in the housing market.
According to the latest Real Estate Institute report, Auckland’s median rental yield is a paltry 2.7 per cent, while Wellington and the Bay of Plenty aren’t much higher at 3.4 and 3.1 per cent.
Holding cash or term deposits is likely to become even more attractive, with the Reserve Bank likely to push the Official Cash Rate a little higher from here.
As always, there’s a catch.
In exchange for this attractive income stream and virtually no risk of losing any capital, investors are forgoing growth.
Well-run companies grow their dividends over time, while properties in good locations experience rental growth.
House and share prices can bounce around, but investors in these assets are likely to enjoy a growing passive income stream, which in turn drive capital growth (over the long-term, at least).
In contrast, cash and term deposits offer no growth and the income they provide – whilst extremely reliable – remains stagnant.
Another drawback could emerge over the next year or two, should the economic winds change.
Just as short-term interest rates have increased sharply over the past 18 months, they will drop just as quickly if the economy runs into trouble and the Reserve Bank reverses course.
Conservative investors might be better off looking at corporate bonds, which are also offering the highest levels of income we’ve seen in years.
One can easily generate a yield of more than five per cent from a portfolio of high-quality bonds, well above what could’ve been achieved a year or two ago.
Many of these bonds have maturities in the two-to-five-year range, which means the income streams are locked in for longer than that of a short-term deposit.
Not only does this offer more income certainty for the future, it also means an investor can avoid being at the mercy of swift changes in market conditions or Reserve Bank policy.
Higher interest rates are proving problematic for over leveraged borrowers, while they’re a headwind for the economy and asset prices too.
For conservative savers, however, the investment landscape and prospective returns haven’t looked this good in years.