ONE IS THE NEW THREE
Mark Lister, 2 November 2020
How to deal with record low interest rates.
The income that investors can expect from term deposits and bonds continues to fall. One per cent is the new three per cent. So, how can investors deal with low interest rates?
Interest rates have declined to new record lows this year as central banks globally look to provide as much economic support as possible in the wake of COVID-19.
Six-month term deposit rates have declined to all-time lows of less than 1.50 per cent. Once tax is taken into account, your return will be struggling to keep pace with increases in the cost of living.
Term deposits aren’t generating the income they used to
Borrowers have benefitted as interest rates have declined, with the cost of servicing debt now dramatically lower than in the past. The monthly payment on a $500,000 mortgage is almost 40 per cent lower than in late 2014 and more than 60 per cent below 2007 levels.
However, what’s been great for borrowers has been terrible for savers. The monthly interest a $500,000 term deposit generates has slumped 70 per cent since 2014 and is a whopping 85per cent lower than where it was in 2007, back when term deposit rates were close to 8 per cent.
Another way to think about this is to consider how much capital you would need to generate an annual income of, let’s say $40,000. Back in 2007, an investor would have required a $502,000 term deposit to bring in that level of income. Today, it would take a staggering $3.3m to achieve the same result.
Size of term deposit needed to generate $40,000 in pre-tax income
What should investors facing this conundrum do?
There’s no easy answer to the income dilemma. The truth is, if you’re in this quandary you only have three real options.
1. First up, spending less is a valid option. However, when you’ve worked hard all your life, you want to enjoy a good standard of living when you retire.
2. The next alternative is to shift your funds into shares or property, both of which can offer higher returns. There’s a catch though. Dividends and rents are far from guaranteed, as recent events have demonstrated. In addition, during shorter periods of time, prices can fall.
The last thing you want is to find yourself needing to cash up your share portfolio or sell your property in the middle of a rough patch when prices are low.
Moving up the risk curve a little bit is an acceptable course of action, in fact it’s a completely logical one if you have a reasonable investment time horizon. Just don’t overdo it. Not every bear market will blow over as quickly as the one from February and March this year.
3. This leaves us with a third option - if you have an investment portfolio you could consider spending the income your portfolio is generating and, when you need more, eat into a little of your capital from time to time.
Many Kiwi investors baulk at the suggestion of this, having trained themselves to think of the capital as sacrosanct. We need to adjust that mindset though. The total return (which is the combination of the capital gains and the income) of an investment portfolio should be considered a pool of income available to be drawn on as required. Not just the interest or dividend payments.
A key advantage of this approach is that there is no need to dramatically adjust your investment philosophy or risk profile for the sake of boosting yield.
Viewing returns as returns – regardless of where they come from – means you can construct or maintain a well-balanced portfolio of assets that matches your tolerance for risk.