Beware the distortions of too-low interest rates

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The Buy Side

Beware the distortions of too-low interest rates

TOM BRADLEY | Columnist profile

From Friday’s Globe and Mail
Published Thursday, Jun. 23, 2011 6:06PM EDT
Last updated Friday, Jun. 24, 2011 6:33AM EDT

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We’ve had low interest rates for years, and really low rates for almost three. We’re used to them, and may even be getting complacent. I had more questions and concerns from clients about rising interest rates a year or two ago than I do now.

Well, I’m here to tell you that it’s not a time to be complacent. Quite the opposite. Low rates are causing enormous distortions in the economy and financial markets, and it’s important to understand them, and try to be on the right side of the divide.

Before explaining, I want to be clear that I’m not calling for interest rates to rise next week. I have no idea where they’re going short term, nor is our bond manager calling for a big change.

But taking a slightly longer view, investors and borrowers need to recognize that interest rates are artificially low. By that I mean, the normal mechanism for setting prices has been tampered with.

The U.S. Federal Reserve is holding short-term rates near zero in hopes of stimulating the economy. As a result, the U.S. government, and other more creditworthy institutions, are able to issue bonds at rates that don’t even offset expected inflation (i.e. the real or after-inflation yield is negative). A five-year U.S. Treasury bond is yielding 1.5 per cent.

This Fed subsidy serves to transfer wealth from the lender to the borrower.

Bill Gross of Pimco describes it well. “The artificial yields, in effect, act as a tax on savings, undercompensating asset holders and transferring the haircut benefits to the debtor nation.”

Who Benefits

Unfortunately, Fed chairman Ben Bernanke can’t control who he subsidizes. So while helping out indebted home owners and the government, he’s also giving a boost to borrowers who don’t need any assistance, including profitable corporations, hedge fund managers and Canadian home buyers. Here come the distortions.

For starters, people saving for retirement, or already living off their investments, are being stolen from. Returns from their bond portfolios won’t be adequate to live off of going forward, let alone keep up with inflation. To attain a reasonable amount of income, they’re forced to take more risk.

By encouraging more risk-taking across a broad range of assets, too-low interest rates push prices up. Corporate bonds are the most visible example, but stocks, real estate and other long-term assets are also affected.

Real estate is a great example. Prices are driven by a number of factors (the economy, jobs, location and, in the current context, Chinese buyers), but they’re always linked tightly to interest rates. With rates where they are, prices on both commercial and residential properties have risen steadily in Canada, with some income properties now being transacted at “cap rates,” or yields, under 4 per cent. A property manager I know describes the availability of cheap credit as “rocket fuel.” Real estate is all about location, location, location, but these days rates, rates, rates aren’t far behind.

Neither a Borrower Nor a Lender Be

So it’s not a great time to be a lender. Yields are low and the assets being financed may be on the pricey side.

Is it a good time to be borrower? Certainly, if you’re refinancing existing obligations, it’s the best. Your cost of borrowing goes down while the value of your asset is going up.

But what about borrowing to buy an asset? Would you rather buy an expensive house with a cheap mortgage, or buy a cheap house with an expensive mortgage?

Of course, there’s only one answer to that question. As an owner, you live with the price forever. Buying low always make the economics work better. Favourable financing terms, on the other hand, are transient. There is a risk that the mortgage has to be renewed at a much higher rate. Unless you’re a government or corporation that can raise 25-year money, you can’t match your liability – your mortgage, in the case of home buyers – to the life of the asset.

Low-cost financing is intoxicating, and it’s nice to be subsidized, but we need to keep our intake in check. And we need to make sure that the valuations on our assets make sense, not just today, but in non-artificial times as well. It’s not a time to be complacent about too-low interest rates and the impact they’re having on the economy and our investment portfolios.

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