Locking-In Interest Rates

The general consensus is that global interest rates are going to start declining this year, after a longer-than-expected run of higher interest rates. Those interest rates started rising when central banks, especially in the US, woke up to the fact that inflation was not ‘transient’ after all and was, in fact, getting out of control. This inflation was an almost direct result of over-generous stimulus packages during the pandemic that amounted to ‘helicopter money’ coupled with supply-side inflation driven by the start of the Ukrainian war.

The stimulation cheques weren’t being sent to the people/ industries who needed it but to anyone and everyone (akin to throwing it out of a helicopter). For many people, this was a sheer windfall, and they did one of 2 things – save it or spend it on (frankly) goodies for themselves – and sales of electronics, for example, spiked. This stimulus party started with Trump’s CARE Act giving one-time, direct cash payments of $1,200 per person (22,300 Banana Rands) plus $500 per child. Trump, in Dec 2020 (when he had already lost the election (according to everyone except him of course) upped the amount to $2000. A cap on earnings of $75,000 per annum (R1.4 million per person – some cap!) was put in place and additional stimulus payments were made during the Biden administration. This massive rise in general liquidity, once spent on tech and toys, started to move into the housing industry. I am sure you can all remember the run on lumber (wood) in the US (which is used in preference to bricks in most of the US). Thanks to the spike in demand (much of it DIY and home improvements) and labour shortages caused by the pandemic, the price of lumber increased 400% in a matter of weeks (going from $12.50 to $48 per sheet of plywood) – the price soon went back down to the $12.50 level again. As the Ukraine war started, oil also spiked and this spike in oil and natural gas was one of the early triggers for inflation.

Inflation usually happens when demand outstrips supply – as we saw in the lumber industry. This applies to talent as well, and when the US got back to full employment, the race was on to secure talent, and that resulted in a wage spike in some industries – including some unlikely suspects like fast food. Unfortunately, when wages go up, they seldom come down – making inflation ‘sticky’. You can see how this all becomes a vicious circle. Perhaps because the inflation spike seemed to be focused on the home-building industry, the FED didn’t see the wider problem until it was too late. The lumber prices soon worked their way back to normal levels.

Obviously the FED, and other central banks, went back to the textbooks and hauled out rising interest rates as a weapon to combat inflation (monetary policy) – and it does seem to have worked… Or did it? Would inflation not have come down naturally once the stimulus cheques were out of the system and supply of goods and services normalized? We’ll never know, but it is interesting to note that unlike previous eras where higher interest rates stifled demand – usually until the country went into recession – this hasn’t really happened this time round, especially in the US. We are definitely in a new normal and governments are probably as much at a loss as we are as to how this is going to play going forward.

The importance of painting a global inflation picture for all of you is to emphasise the lack of clarity in the dynamics that are unfolding – in countries, markets, currencies and interest rates. High interest rates are hard on anyone who has debt, and repayments that were affordable before 2020 are now significantly higher. (The anomaly of the pandemic years is going to mess with statistics for a long time to come and it’s coming to the point where we play the schoolyard trick of …one, two, skip a few hundred – instead its 2018, 2019, skip a few 2023). For investors though, these higher interest rates are a godsend. Income-generating portfolios can be constructed to tap into these yields to pay out to clients without having to sell units all the time to produce that income, thus stabilizing the capital. These high interest rates also mean that after clients have been paid out their income (at say 4.5% of the capital) there is more than enough to be reinvested and to compound the capital.

High rates also mean that growth portfolios can be bolstered and buffered by income without sacrificing too much return – reducing the angst that comes with excessive volatility which we often see in stock markets (and is compounded by a fluctuating rand in offshore portfolio values).

For those of you who aren’t that familiar with boring old bonds – here are some ways that you can lock in some of those high interest rates for the foreseeable future:

Your Discretionary Asset Manager (who can look after both flexible onshore and offshore investments as well as investments controlled by the Pensions Fund Act (Retirement Annuities, Living Annuities etc)) can add bonds into your portfolio – without having to go into bond funds with a whole new layer of fees. The yield of a government bond changes daily and is currently at 9.8% for a 10-year bond (with a well-established secondary market if you need to get rid of them). Retail bonds are even higher at 10.5% for a 5-year bond. Many banks also have interest rates around this mark – but please don’t be fooled by the (dubious and misleading) use of effective interest rates that make a simple 10.5% pa interest rate look like 13% by compounding daily over the full term. Compare apples with apples. If you want to lock in the rate in the money market, then look at 60-month terms. Corporate bonds, widely used in income portfolios, are linked to JIBAR (the interest rates effectively) and so do not lock in the rates. There are also a couple of good, low-cost/high-yield income funds that can be used to good effect without resorting to the one-fund-fits-all, high fee Balanced Fund – but are also going to re-rate down as the interest rates drop.

Building a sustainable income portfolio, that preserves and grows capital with the income paid out increasingly each year (for example for an annuity) is complicated and advisors may just default to a balanced fund they know well with a money market pocket on the side to hold the annual payout.  I liken this to having a salami. The advisor will cut off a slice of the salami and send the piece off to you, hoping the salami will grow back that slice, and more in the ensuing year. They are probably going to cut that slice off and stick it in a cash pocket, hauling it out of the fridge every month to pay you. That strategy is based on hope, not certainty. If that slice is cut off at a downturn point in the market, and then stuck in a low-yielding cash fund, it can have a nasty impact, especially if that drawdown is higher than the prudent 5% per annum. You can take a different view – and use a different analogy. You can invest in a cow, and the advisor gives you some of the milk, feeding the rest to the calf so that you grow your herd, year by year instead of relying on the vagaries of the market. This approach requires a critical mass of around R4m, which is not excessive for retirement income funds and only equates to around R15-R18k per month in income – before tax. Contrary to popular opinion, formal retirement funds can fairly easily be changed from one provider to another (with no fees) unless you’ve been sucked into an Insurance Provider product where upfront commission is paid to the broker and you have an early termination penalty. If the broker has chosen to take upfront commission as well, that is long gone out of your capital and you aren’t ever going to see it again – but it is no reason for you to stay on a sub-par investment. It is human nature to hang in there and insist that an investment pay for its breakfast – but investments have no feelings. They cannot be cajoled into performance. They need to be nurtured and placed in an environment where the market can pull them along without excessive fee encumbrances.