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Safety is the key as interest rates continue to fall
2 min read.Updated: 07 Jul 2020, 08:43 PM ISTVijay Bhambwani
Vanilla economic theory suggests that lower interest rates spur growth as producers get funds at lower cost, which aids the production of cheaper goods. This ignores the needs of depositors. Mint takes a look
Yields enjoyed by fixed income securities’ investors are headed lower. Vanilla economic theory suggests that lower interest rates spur growth as producers get funds at lower cost, which aids the production of cheaper goods. This ignores the needs of depositors. Mint takes a look.
Governments in various countries are providing stimulus to their economies to combat the covid-19-induced slowdown. This stimulus involves printing currency that is not backed by gold or other resources and assets. The simple equation of demand and supply means that supply of money is going up and, therefore, its purchasing power is going down. As such, the cost of living will go up. Household expenses will mount. As an increasing number of people will have more money, they will try to save it and cause an over-supply. Consequently, the borrowers, such as banks, will offer lower interest rates.
How do falling rates hit the banking system?
Falling interest rates simply means that the segment of the population dependent on passive, fixed income—often senior citizens, will fall short of their required returns. This segment has the highest savings, with a lifetime of earnings behind them. At lower rates of returns, they are likely to turn away from investments that are yielding falling returns and move towards high yielding avenues. It also holds risks for the country’s banking system and the economy. Savings are important for capital formation. If banks are unable to get deposits, they will unable to lend as much to infra projects, which are crucial for development
Can investors hope to return to assured higher returns?
The coronavirus pandemic might have only extended the trend of falling interest rates. This means there are bigger challenges in store for investors depending on fixed income avenues. Revenue streams for governments are drying up and it will be difficult for them to continue offering higher guaranteed income schemes.
In the investing world, there is risk and return, which an investor needs to balance. Yardsticks such as Jensen’s Measure tell us whether or not taking an additional unit of risk is likely to yield an additional unit of return. When fixed income investors pull money out of fixed deposits or sovereign guaranteed bonds and deploy it in equities, for instance, they expose themselves to a lot of hardship. This means the investors are taking risks beyond acceptable limits and this may not be commensurate with the returns.
What can an investor do amid falling rates?
If rates are generally headed lower, there is little an individual can do. However, investors can act to protect their capital. People in the 25-45 year age group can absorb risks, but older people should choose to invest money only in government-guaranteed schemes and bonds though they offer lower rates of returns, but will never default on commitments. Printing currency is not an option available to private sector bond issuers, and so those borrowers might default. .
Vijay Bhambwani is the editor of Fast Profits Daily, a publication of Equitymaster.