Higher interest rates have been in the news since last year, with US Federal Reserve rate hikes slowing only at the start of 2024. Due to the increasing chaos from the Russian invasion of Ukraine, and further issues in Gaza, it’s uncertain what direction we’re headed in for the rest of the year – but in the meantime, financial advisors, relationship managers, etc. are scrambling to come up with ways to explain the impact on your portfolio. The common question here is: are rising interest rates good or bad for you? And while this is very situational, here’s an attempt to clarify it:
First, what’s the big deal with Federal reserve rates, and why do Singaporeans care?
A quick – if somewhat oversimplified – explanation is due here:
The Singapore Overnight Rate Average (SORA) reflects the lending rate between banks (older readers may remember SIBOR and SOR, but SORA is the rate that’s replacing these).
SORA determines the interest rate of many loans, such as home loan rates; and SORA tends to move in tandem with the Fed rate. When the US pegs its interest rates higher, SORA tends to rise, and vice-versa.
The US tends to lower its interest rates in times of crisis, because this pumps more cash into the economy and stimulates it. However, long periods of easy money lead to higher inflation, which the US has been experiencing in the aftermath of Covid. As such, the Fed has aggressively hiked interest rates, which lowers inflation but raises borrowing costs for businesses.
Despite what the old Chinese-educated uncle in the coffee shop says, the US is the world’s most important economy; and when they raise or lower their interest rates, Singaporeans – and most of the world – feel the effects.
So are you winning or losing when rates rise?
This depends on your immediate financial situation. The effects differ for:
- Equities and equity funds
- Bond and bond funds
- Fixed deposits and savings accounts
- Real estate portfolios
- Income vs. assets
1. Equities and equity funds
Generally speaking, higher interest rates are bad for stocks; so you would expect equities and equity funds to see weaker performance.
The main reason is that most businesses need leverage – the more expensive it is for them to borrow, the slower they tend to grow. They hire fewer people, they give out fewer raises (yes, this is actually bad for business, because top-tier talents may quit), and they cancel more ambitious projects like expanding to another country. Earnings projects also tend to fall, when businesses find they need to pay back much more in terms of interest. This lowers potential future earnings, which also affects their stock valuation.
If you want to be an absolute finance nerd about it, valuation models like the Discounted Cash Flow (DCF) model, which discounts future cash flows back to present value, will tend to show lower valuations as interest rates rise. And because Wall Street worships this kind of mathematical gibberish, it’s bad news for your portfolio.
There’s also the likelihood that people will start to spend less as interest rates rise, because the mortgage isn’t going to pay itself; so they’ll cut back on some luxuries, and the relevant businesses will suffer. With higher interest rates, people are – in theory – less likely to turn to credit cards and personal loans, and go back to old-fashioned saving and waiting. This is, again, bad for business.
Finally, as more investors come to grips with this, they tend to cash out of equities and move into other assets. If you sell too late (i.e., when others have all caught on), you’re probably going to see some losses*.
*On the flip side, if you’re optimistic that a business can stay strong and recover, it may be a good time to find discounted stocks.
2. Bond and bond funds
Bonds have an inverse relation to interest rates: as interest rates rise, bond values fall, and vice versa.
Think of it this way: if you bought a bond when interest rates were at 3%, but newly issued bonds are at a higher rate of 5%, then the previous batch of 3% bonds are now less valuable. Why would anyone pay more for them, when they can just buy newer bonds which have higher yields? The impact of higher interest rates also worsen as a bond’s maturity period gets longer, or its coupon rate is lower.
For bond funds though, this is where the skill of the fund manager kicks in, and they get to convince you they’re worth the fees. Rising interest rates do tend to raise the risk of capital losses for bond funds; but at the same time, a bond fund can also buy new bonds with higher interest rates, to try and mitigate the losses. It comes down to critical balancing decisions like whether to increase the exposure to higher risk, higher yielding bonds (e.g., exposure to junk bonds).
In general though, assume that higher interest rates are bad for bonds; and if you have an actively managed bond fund, then hopefully the fund manager can at least minimise the damage. I wouldn’t get my hopes up though.
3. Fixed deposits and savings accounts
For fixed deposits, it depends on whether you’re looking for a fixed deposit just now, or whether you’re already locked into one.
If you’re just now looking for one, you’re in luck: the rates are likely to be much higher, so rising interest is a clear win. But if you’re already locked into a fixed deposit from years earlier, with a much lower rate, then you’re losing out. That’s the old opportunity-cost kicking in.
(You can try to pull your money out and reinvest it, but that incurs a penalty; often the loss of all accrued interest, so it’s not always worth it. Have a professional crunch the numbers for you).
For savings accounts though, most banks will raise the interest by at least a little bit. This may involve jumping through the proverbial flaming hoops (e.g., earn bonus interest by putting your paycheque with the same bank, getting your home loan from the same bank, spending $500 a month on a card from the same bank), but you are likely to find improved “bonus saving tiers.”
4. Real estate portfolios
Generally, higher interest rates are bad for real estate assets, unless you’ve already paid off the house; then the interest rates may not matter as much.
HDB loans are also less affected, as HDB loan rates are always 0.1% above the prevailing CPF rate, and that hasn’t changed since the T-Rex roamed the Earth. The HDB loan rate of 2.6% is about the closest thing we have to a perpetual fixed rate, as bank loans always fluctuate (even if they’re fixed, they are only fixed for a certain duration like three to five years).
But that doesn’t mean the HDB loan rate offers total protection from rising interest. The CPF rate is revised every quarter, and just because it hasn’t changed in a long time, doesn’t mean it will never change. There’s a non-zero chance that CPF rates will rise to meet new interest rates, and that could cause the HDB loan to get more expensive.
For landlords who have existing mortgages, it will boil down to how much more you can charge; not every tenant will roll over and accept a higher interest rate. This is where a good realtor may come in handy.
As higher interest rates affect the cost of borrowing, and also impact lending limits (e.g., TDSR and MSR requirements or qualify for a home loan), sellers should in theory be pressured to lower prices, or at least be unable to raise prices. But Singapore may prove an exception to the theory, due to our abnormally high home ownership rate of around 80% (this means few sellers will be so desperate that they can’t wait for a better price).
5. Income vs. assets
Rising interest rates tend to have a bigger impact on asset values, as opposed to disposable income.
This isn’t to say rising interest rates won’t hurt your income: they can, albeit in a less direct way. You might, for instance, find your purchasing power decreased if your home loan, car loan, personal loans, etc. are much more expensive. However, this isn’t something that happens overnight, and many people can go months – or even a year or two – without feeling it.
The impact on stock values, home prices, bonds, and other assets, however, is much more immediate. As such, people with more in the way of assets (e.g., the asset rich and cash poor) could feel the impact of interest rates much quicker than their counterparts. Note that age has an effect here, as older Singaporeans are more likely to have assets like property, equity portfolios, gold, etc. as compared to a young Singaporean just entering the workforce.
What’s the lesson here? Rebalance!
Don’t just sit still and let interest rates wreck your portfolio; and feel free to let in some of that FOMO vibe. Now is a good time to talk to your financial advisor (or other qualified expert) on how the rates are affecting each aspect of your portfolio; and what your tactical asset allocation should look like.
If you have questions about this, let us know at Single Digit Millionaire.com
