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Low interest rates won’t last forever

Low interest rates are set to continue for another year or more. 
Find out how farmers can make the most of the current environment

Interest rates are due to rise and, as the world waits for low single digit interest and borrowing rates to rise to historical norms, mischief stalks the land. Far from the canyons of Wall and Bay streets, farmers are at risk of having to pay more to borrow money and, as a result, earning less when costs are deducted from revenues. Yet the bad news conceals the good, for along with higher interest rates goes improvement of the economy.

The summer was a time of fear of rising interest rates. In the bond market, where interest rates are the pulse of the economy, traders and institutional investors running billions for insurance companies and pension funds ran for cover in mid-June. Following remarks by Federal Reserve Chairman Ben Bernanke on June 19 suggesting that interest rates might rise by fall, bond prices collapsed. Investors sold bonds, terrified that the very low interest rates they were receiving would soon be laughable and the bonds that paid them worth relatively little. They moved to cash or very short term bonds that revert to cash in a month or two, to await higher interest rates.

Dumping vast holdings of government bonds, high yield bonds and investment grade corporate bonds, traders and institutional investors sent yields, which move opposite to interest rates, soaring. In the third week of June, the 10-year Government of Canada bond posted a yield of 2.55 per cent, up from 1.87 per cent at the end of March. The 10-year U.S. Treasury bond dropped so far that it yielded 2.75 per cent, up from 1.85 per cent at the end of March. For ordinary investors who buy and hold bonds to maturity, the rise in rates was good news. For the first time in almost five years, bond interest would match or exceed inflation.

Mid-July change

A month later, the rush to raise cash seemed premature. Seeing what he had wrought, Mr. Bernanke promised in mid-July that there would be no change in interest rate policy until the end of 2013 or maybe 2014. Price supports for bonds in the form of US$85 billion purchases every month would continue. In Canada, the new head of the central bank, Stephen Poloz, said the benchmark short term rate, one per cent, would remain in effect for another year.

Interest rates will go up — that is a certainty. But the triggers, which would be a rise of U.S. inflation to two per cent from the current 1.4 per cent rate and a decline of unemployment to seven per cent from 7.6 per cent at present remain elusive. GDP growth in Canada is 1.8 per cent and, in the U.S., 1.6 per cent, according to the economics department of Scotiabank.

The June bond yield spike, which influences all other credit markets, turns out to have been a bubble. Bill Gross, co-chair of PIMCO, the world’s largest bond portfolio managers, said on June 19 that he thought the chances slim that U.S. inflation and GDP growth would rise enough to justify the Fed’s withdrawal from markets. Events have proven him right.

Message from the markets

For now, the message of markets is just this: hang tight, borrow cheaply while you can and lock in low mortgage and line of credit interest rates. If you want to buy a new combine, get a line of credit and fix the terms now, even if you plan to order in a couple of months.

Higher interest rates mean that house mortgages would cost five to six per cent for five-year terms. That means people could afford less house. Companies like big utilities and telecoms as well as chartered banks would find their borrowing costs much higher and would therefore tend to report lower earnings, all other things being the same as before rates rose.

You might think that low interest rates are a blessing, for borrowing costs are mostly modest and, if you want a higher return, you can buy dividend-rich stocks from the very companies that make more profits because they can borrow cheaply. However, there is a dark side to the low inflation that makes low interest rates possible. Low inflation means that it takes longer to pay off debt. Thus the real value of debt is higher when inflation is low. It tends to act as a brake on the economy. Very high interest rates that go with high inflation are also destabilizing. The sweet spot of inflation and interest is at 2.5 to three per cent inflation and four per cent short interest rates. But that is a long way off.

What can you do?

What should farmers do in the present environment? The present structure of interest rates implies that it is a good deal to borrow long on a fixed term if the premium for the long loan compared to a short or floating rate is not too large. There is a term premium, that is, a bonus paid to the lender by the borrower for the risk of carrying long-term debt. The normal 10-year premium is about four per cent, so that if a 90-day Treasury bill (the same thing as a 90-day bond) yields one per cent, the 10 year bond should pay five per cent. Today, the premium is artificially suppressed at less than two per cent. It won’t be this small forever. When rates normalize, so will the premium.

If you can get a 10-year loan for four per cent or less over a three-month loan, really a floating rate line of credit, then it’s a good deal. If the lender wants six per cent or more for the 10-year loan over the floating rate line of credit, stick with the short loan.

Interest rates on investment grade corporate bonds follow those on trend-setting government bonds. Numerous companies pay four per cent on their long term bonds, implying a two per cent term premium. It’s not good enough, for though you will get the interest you sign up for, it will be relatively unattractive when rates rise in a few years.

If you want to invest and have a promise of a return of your investment, you have to buy actual bonds. When you invest in a fund that rolls over its bonds forever, you give up the fundamental guarantee of return of capital at a fixed date.

Dividend-paying common stock, on the other hand, has no promised return of capital, but you can make educated bets that, over time, solid companies like BCE Inc., which has a dividend of about five per cent, will raise payouts, that their prices will rise, and that the combination of higher dividends and higher stock prices will pace inflation. Common stock is not a proxy for a bond; indeed, they are different critters. The bond is an obligation and bond holders can sue for payment of interest and return of capital. On the other hand, a share of stock is a venture with the company and nothing is promised. Yet over time, stocks pay far more than bonds. Canada’s big six banks have rewarded their holders handsomely with rich and growing dividends and rising stock prices.

The market overreacted in June to the hint that interest rates would rise. Since then, monetary authorities around the world have said in unison, “not yet.” One could add “not much.” Bottom line — it is better to be a borrower at today’s rates than a lender. †

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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