Dealing With Low Interest Rates

Rates have been lowered again. It’s a wakeup call to think about rates in general and the bond market in particular.

Bear in mind I am talking about government bonds, not investment bonds which are tax paid investments just like your superannuation.

The thing about bonds is that their market value increases as interest rates drop. Obviously, if I have a government bond paying 4% per annum, and rates drop to 2% per annum, the value of my bond will rise ,because 2% has become the current going rate, and my bond is paying 4%. So, in the last 10 years as interest rates have gone down and down and down, bonds have had a bull market. For the for the last year, European bonds have returned 9%.

But those days are gone. Most government bonds in Europe are now yielding negative returns, but under European law pension funds are forced to invest in them. Therefore, fund managers are investing heavily in bonds which they know they will lose money on.

Surely interest rates cannot fall much further in Europe. Once rates reach negative territory savers are penalised for having money in the bank, and, as I pointed out recently, home borrowers in Denmark are now having their mortgage payments paid to them from the bank instead of them paying them to

Here’s the crunch – the moment rates start to go up, bonds will enter a bear market and their values will tumble. The pension fund managers in Europe will be stuck with owning financial instruments with a negative interest rate, at the same time as the capital value is falling. It will be a bloodbath. Bonds will not become worthless, because there is still a guarantee of the capital value of maturity, but some of these have a term of 50 years.

So what are the alternatives- cash property and shares. Cash is yielding next to nothing leaving us with property and shares.

The thing about property, is that it has a sense of permanence, and should increase in value if it is a quality building

Now think about shares – when you own a share, you are owning part of a business. Even if there was a bond crisis, the businesses in whose shares you own should still prosper, and keep paying you dividends. This is why I think that good property and good shares will continue to do well, provided you stay in there for the long term.

Just remember we are in uncharted waters. Make sure to keep enough cash on hand for three years planned expenses.