INTEREST rates have a wide and varied impact upon the economy. When interest rates are raised, the general effect is to slow down credit demand and contain inflationary pressures. It also makes borrowing money more expensive, which affects how consumers and businesses spend their money. Investors should understand how interest rates affect their investments in equities and bonds.

Definition of interest rates

An interest rate is the rate of which interest is paid by a borrower to the lender for the use of money. Interest rates are normally expressed as a percentage rate over the period of one year. The use of interest rates by central banks to influence economic activity is known as monetary policy. It should be noted that the main objectives of most central banks is to maintain price stability, i.e. a stable inflation rate while the secondary objective is to support economic growth.

To a certain extent, central banks are able to influence economic activity by adjusting the interest rates on the funds lent to or borrowed from the retail banks. Typically, lower interest rates will result in stronger demand for loans and this will lead to an increase in economic activities as consumers borrow to spend and businesses borrow to expand their operations. Conversely, an increase in interest rates will raise the cost of borrowing and thus reduce loan growth, causing investment and economic activities to slow down.

"Low interest rate isgood for the economy"

We often hear that phrase. How does low interest rate actually bring economic growth? Well, lower interest rate means reduced borrowing costs for consumers, companies, government, etc. This in turn encourages purchase of big-ticket items such as motor vehicles and properties by consumers and higher investment spending by businesses. This increased spending will act as a catalyst to create further demand for goods and services down the supply chain.

In addition, low interest rates can positively impact certain businesses as well. For example, property developers benefit from low interest rates since it becomes easier to sell real estate. As loans become cheaper, consumer demand for mortgages and other lending products will rise. At the same time, banks will benefit from this increased activity. As banks pay lower rates on deposits and other interest bearing accounts, they also benefit from the lower cost of funds and may enjoy wider net interest margins if their lending rates have not been reduced by as much as deposit rates.

The flip side

Based on the points described above, it would seem like keeping interest rates low is a highly effective policy in stimulating economic growth. Like all good things, nothing comes without risks or trade-offs.

For starters, lower interest rates reduce the interest income earned by individual savers as well as institutions. For example, many households depend on interest income to meet their living expenses and future retirement needs. Pension funds depend on recurring income to meet their present and future liabilities. Interest revenue forms a key portion of the revenue for many financial institutions.

Secondly, a policy of keeping interest rates artificially low for an extended period and below the rate of inflation could lead to the formation of excesses in asset prices. Investors may engage in speculative activities that could cause asset prices to rise well above their fundamental values. Over time, this will inevitably lead to a sharp retracement in asset prices and result in adverse effects for the overall economy. In addition, the decline in asset prices may potentially cause volatility in financial markets.

Impact of interest rates onstock and bond markets

Interest rate movement has a direct impact on the economy and the flow of investment money.

As an individual investor, you can benefit from such movements by diversifying your investment portfolio with a mix of both equity funds and bond funds. Investing in equity funds allow investors access to a diversified selection of stocks without having to micro-manage the buying and selling of stocks. Likewise, with bond funds, retail investors are able to participate in bond investing. Bonds are traditionally limited to institutional investors since they require a large investment amount as the minimum value of a single bond normally starts from RM5 million.

The relationship between stock market and interest rate is more indirect unlike the relationship between bond prices and interest rate. When a central bank announces a decision to lower interest rates, stock markets usually go up as the cost of borrowing declines and businesses are able to expand at lower financing costs during times of low interest rates. Investors can capitalise on this by investing in equity funds, especially those that focuses on growth companies. However, it may take time to see the impact of lower interest rates on companies' earnings or economic activities as a whole.

Meanwhile, the relationship between bond prices and interest rates is directly inverse. When interest rates go up, bond prices go down and vice-versa. In other words, the net asset value (NAV) of a bond fund changes as the value of the underlying bonds change. However, under certain circumstances, higher interest rates may not necessarily cause bond prices to decline if (a) the interest rate hike is aimed at normalising interest rates and (b) the interest rate hike is viewed as an effective measure to contain inflationary pressures.

For instance, Bank Negara Malaysia's move to normalise the Overnight Policy Rate from a low of two per cent in February 2010 to three per cent in May 2011 in tandem with the recovery of the Malaysian economy did not cause the local bond market to retrace (source: Bloomberg).

In conclusion, interest rate trends are one of the many economic indicators that investors can monitor to help them make better investment decisions. As an individual investor, you should understand how interest rates affect your investment but at the same time you should also know that interest rates alone do not fully explain the short-term performance of stocks or bonds.

Over the medium to long-term, stock performance is driven by corporate earnings growth and sustainable cash flows. While the interest rate environment does affect bond returns, bond investments that are held to maturity are often not affected by short-term interest rate cycles while other factors such as credit quality and cash flows are more significant factors. As such, investors should always adopt a prudent approach to their investments by diversifying across asset classes and focus on their long-term goals to mitigate the effects of volatility in the markets.

This article is contributed by Public Mutual Berhad. For more information, you can call Public Mutual Hotline at 03-6207 5000 or visit www.publicmutual.com.my.

SOURCE: Business Times