Are low interest rates a free lunch?
On its face, it sure looks like it. Low interest rates reduce government interest expense, make it cheaper to borrow, and stimulate the economy. They especially prop up the housing sector, which goes a long way towards recapitalizing the banks. And ultra-low short rates allow the banks to borrow short and lend long, boosting their net interest income. What’s not to like?
But ultra-easy monetary policy will have unexpected second and third-order effects. For example, low rates are a real problem for savers. With inflation at 2%, zero percent short-term rates means that purchasing power is eroding year-by-year. As investors’ bond portfolios gradually mature, the interest income they can earn on new investments is significantly lower. Many people who live off their interest income are now getting squeezed. Now they are asking where they can cut back.
These investors are also exploring alternative ways of generating income. Some are looking at dividend stocks: others are using real-estate investments; high-yield bonds or other alternatives are also being considered. In any case, income-sensitive investors are taking more risk in order to continue to generate the required interest.
This additional risk will come back to bite the unwary. Longer-term bond portfolios are much more sensitive to interest rates; dividend-growth equity strategies make a portfolio more volatile when used as a substitute for bonds, and so on. Risk is part of investing. But if it’s not managed properly—if investors reach for yield and get burned in the process—the entire economy will suffer.
There’s still no such thing as a free lunch.
Douglas R. Tengdin, CFA
Chief Investment Officer
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