How interest rate increase affects assets in your portfolio
Interest rates have a dual function: it either serves as the cost of borrowing, or compensation for saving funds.
The Central Bank sets interest rates that it pays commercial banks when they save money with it, and charges when they borrow money from it. The commercial banks then use this as a benchmark to set interest rates for their customers.
The Bank of Ghana (BoG), has increased its interest rates to 22% to tame inflation, which is currently high at 33.9%. This affects the assets in your portfolio in various ways.
Bonds prices will fall
A bond is a debt instrument issued by the government and corporate entities to raise funds from the public.
Since it is a form of borrowing, they compensate you with interest payment, (also known as yield) periodically for borrowing your money to them. Your capital will be refunded at the maturity date of the bond.
Bond buyers can be categorized into two: Those that buy and hold long-term to earn interest till maturity and those that buy to trade once the price appreciates.
Firstly, those who buy to trade usually buy short term bonds typically 2 to 4 year maturity periods. Even if interest rates increase, chances are they would have enjoyed a good part of the bonds, and so can sell at a loss.
Secondly, those who buy and hold for long periods, usually buy long term bonds with 10 to 20 year maturity periods. When the BOG hikes interest rates, they are affected more because they are stuck with low interest payments for a long time.
However the beauty of the capital market is that they can chose to sell off the bonds, and recoup their money but at what price?
Interest rate hikes mean their old bonds are no longer attractive to buyers, who now want to buy the newer bonds with higher interest rate payments.
If you urgently need money, you have no choice than to sell at a lower price and accept a loss. This is the logic: current yield is the interest the buyer of your bonds will enjoy, for the remainder of its lifespan
Current yield = (annual coupon payment/market price) x 100
Assume you own a 10 year bond that is already 5 years into its lifespan, and you bought it for $1,000 and it pays you 5% or $50 annually.
You run into financial difficulty and decide to sell for $800 so the buyer will calculate the current yield he will be getting if he buys your bond as $50/$800 x 100 = 6.25%
However if there is a new bond in town offering 8%, the buyer rejects your bonds and opts for the one with higher interest. To bring him back to the negotiating table, you lower the price to $600
Current yield now becomes $50/$600 x 100 = 8.3% and you have a deal
When the interest rate increases, the value of bonds falls. This is because investors neglect the older bonds and go for the newer bonds that are less risky, and carry higher yields.
Ghana’s Eurobonds have also suffered downgrade by credit rating agencies due to Ghana’s high interest rate. Credit rating agencies fear that though Ghana is seeking IMF loans, a condition for the loans might be debt restructuring, where bond interest rates may be renegotiated.
If you own these Eurobonds, selling them off might be difficult as buyers always check the credit rating of a bond before buying.
Value stocks outperform growth stocks
Value stock are stock of old established companies that have been around for years. They have robust balance sheets, and are not as heavily indebted.
Their share price may not be very handsome because during economic booms, they are shunned by some investors in favour of stock whose prices rise more frequently.
Value stock could sometimes have low price to earnings (PE) ratio because investors are paying less than what the share is worth, so they are undervalued.
Growth stock are mostly those of new startups and they are usually heavily indebted or leveraged, since they need loans to grow, and expand their business.
Some could have very high PE ratios not because they are very profitable, but because people see promise in them. This makes investors pay more than what the share is worth with the hope of recouping in future.
When the BoG increases interest rates, growth stocks suffer because they pay higher interest trying to service their numerous loans. Also, their value decreases because of the changes in discount rates.
Value stock on the other hand are not heavily leveraged, so the interest rate hike may not affect them as much, and they post steady profits and pay dividends. If you have more of growth stock in your portfolio, it may suffer when interest rates are increased.
When interest rates are high, growth companies that can’t meet up with debt obligation, could quit the country by selling off their stake.
Example, Vodafone Ghana had agreed to sell off its 70% stake to Telecel group due to unprofitability, and issues servicing its $900m debt it used in purchasing the 70% stake initially.
However Ghana telecom regulator has turned down the deal and issued a public statement explaining why the deal was rejected.
Issues like this could affect the share price of companies, and in the end your portfolio is affected if you hold the shares.
You earn more interest on savings account and debt instruments
A savings account is an account provided by the bank which allows you to deposit money and earn interest periodically. You can withdraw your money anytime you want it.
Fixed deposit accounts offer you a higher interest rate but require you to lock in funds for a certain period. You can’t withdraw your funds before the maturity date unless you are ready to forfeit the interest.
The interest you get on savings and fixed deposit accounts is dependent on the current interest rate in Ghana. The higher the interest rate, the more money you get as interest on your funds.
Treasury bills, a short-term government debt, and are just like bonds but their lifespan is 91, 182, and 364 days only. The interest rate on BoG treasury bills also changes when interest rates are hiked.
Current account holders pay more interest on their loans
A current account is used by corporate organizations who intend to take loans or credit sometimes in the future.
The current account has a unique feature known as an overdraft. With an overdraft, you can withdraw more than what you have in your current account balance. You repay the overdrawn balance with the current interest rate. You can also issue cheque with a current account.
You have to pay more commissions for running a current account and higher interest charges on the overdraft when the interest rate increases.
Remember that diversification is key
Diversification means spreading your investment across different classes of assets in order to reduce risks. You can diversify by adding Exchange Traded Funds (ETFs) and Mutual Funds to your portfolio to minimize the adverse effects of increased interest rates.
An ETF is a fund containing various assets like stocks and bonds. They are traded on the Ghana Stock Exchange (GSE) like regular stocks.
Mutual Funds are also similar to ETFs because they comprise various assets. The major difference is that while ETFs are traded on the GSE, mutual funds are not.
With mutual funds and ETFs in your portfolio, you will be sure that while some assets are adversely affected by interest rates, others would not since you hold different classes of assets.
Leveraged investments should be minimized
Leverage allows you to utilize more funds than what you have in your trading account. The margin requirement of your broker determines leverage.
For example, if the margin required for you to open a position is 1%, it means that the leverage is 100:1. With $1,000, you can open a position worth $100,000.
Leveraged investments come in various products such as:
- securities lending or short selling
- retail online forex trading
Firstly, short selling has to do with borrowing stock from a stockbroker and selling it then waiting for the stock price to fall before re-buying it and returning to the broker. It is usually done on margin
You deposit some form of collateral cash or stocks and pay interest every night your short is left uncovered.
Secondly, retail online forex trading is popular in Ghana & there are estimated to be around 30,000 retail traders in Ghana who are trading via foreign brokerages. This is because there is currently no regulation for online forex trading by the BoG, although it is not illegal.
But in many other African countries, forex trading is regulated. For example, there are a number of South African forex brokers accepting foreign traders including HotForex, FXTM, FXPro, who are licensed by the FSCA & also accept traders from Ghana & other West African countries.
These brokers offer trading on various instruments as CFD contracts. Here you use derivative contracts called Contract for difference (CFD) to take a position as to where you think the price of a currency pair will go.
CFDs are structured in such a way that they use leverage, where you put down some cash and your broker lends you the rest.
You also pay interest on the loan for as many nights as your trade is running, till you exit the trade. Any changes in interest rates cause volatility in the financial markets & this can increase the risk of losing big in your leveraged positions.
You should minimize the use of leverage on financial products like spread betting, short selling, and CFD trading.
Final words
The changes in the interest rates can affect your investment positively or negatively. This does not mean that you should sell off your assets if they are not doing well.
Diversifying your portfolio with ETFs and Mutual funds would reduce interest rate risks. It is also important to use moderate leverage ratios.