Wednesday, October 14, 2009

What If Interest Rates Increase?

Interest rates are low. Very low. I pay less than 1% on most of my mortgages and earn close to zero on cash in the bank. This ultra low interest rate environment will not last forever (absent a Japan style perpetual deflation).

So what happens to my finances if interest rates start to rise?

All other things being equal, if interest rates start to rise I would expect the following:

1. most assets will start to look less attractive: yields on fixed rate bonds, equities and real estate will all look less attractive and may fall in price

2. borrowers will try to lock in low rates while they can: lots of bond and note issues. Costs to borrowers will start to rise

3. cash will be crowned king (again). Holding cash will, in the short term, be a sound investment

4. floating rate bonds and notes should hold their value (and may even appreciate)

5. option premiums will rise due to the interest rate component of option prices and (potentially) higher volatility expectations

Based on the above, my finances would take a beating:

A. I have used mortgage finance for all my Hong Kong property purchases. All my mortgages float and are linked to either one or three month HIBOR. The effects of rising interest rates would be felt almost immediately. While I run a positive cash flow (assuming full occupancy), it will not take much in the way of interest rate increases to reverse this position. Since the cost of fixing an interest rate for longer terms is prohibitive (you have to assume very large increases in rates), the correct strategy is to make early payments once interest rates cross a pre-determined threshold. I need to decide what that threshold will be.

B. The value of my real estate may decline. However I see no reason why rents would fall. This means that I should not be in a hurry to sell properties in order to discharge debt. Given the transactional costs and the role properties play in my retirement planning, I would prefer to ride out the cycle.

C. The value of my share/fund portfolio may decline. There may be an adverse impact on dividends. It would pay to weight the portfolio towards companies with net cash rather than net debt. Possibly banks as well as they may benefit from expansion of their interest margins. I suspect that I would be a net seller of equities while interest rates rise.

D. Once interest rates appear to have reached their high point, I will start to buy assets again. Possibly long term bonds (not that easy in Hong Kong), equities and real estate (although I already have enough exposure to the latter).

In terms of strategy, the best way for me to deal with a rise in interest rates is to (i) defer making new investments (ii) hold my properties (iii) review the equity portfolio and tilt towards companies with net cash (iv) build cash reserves and/or write more options and (v) if interest rates reach a pre-determined level, start paying down some of the mortgages. If a suitable fixed rate mortgage came onto the market, I could consider a refinancing. However, given the current slope of the HIBOR yield curve, I would consider that unlikely.

This is all a bit tentative because there have been times when rising interest rates have been accompanied by rising asset values. This is usually a product of either demand lead growth or deregulation of some kind (or both) or because of inflation (actual or expected). It is for this reason that, even though I expect interest rates to rise at some point, I will not be making substantial alterations to the portfolio in anticipation. Rather, I will deal with the situation when it arises and focus on the longer terms goals.

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