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The effects of low interest rates

Interest rates in Australia and around the world have hit historically low levels. So low, in fact, that for around 30 per cent of developed countries, investing in sovereign bonds will provide negative returns after adjusting for inflation.

As Government bonds are considered 'risk free' (by virtue of the Government's ability to raise taxes), they are considered the benchmark for all investment returns, and this has major implications for markets and investors.

Why are interest rates so low?

There are many reasons for low interest rates, including the GFC, the need to stimulate economic activity, the larger amount of debt on issue, the ineffectiveness of the Reserve Bank of Australia's monetary policy and the unwillingness to use fiscal policy.

What are the implications for the economy?

The significant decline in interest rates means that bonds are coming to the end of a 30 plus year rally. For investors, it is now very difficult from here to make capital gains on bonds whilst the running yield is so low.

As a result of the low bond and cash rates, there has been a flight to higher-yielding instruments such as corporate bonds and high-yield credit. This is pushing up the price and reducing the yield of these instruments, while at the same time investors may be taking on unintended risk.

Other asset classes such as high-yielding property trusts, infrastructure assets and high-yielding equities have been pushed up substantially in terms of price.

There are also a number of other less talked about implications. One is that insurance companies that hedge their liabilities out a long way via fixed interest are finding it difficult to immunise their liabilities at such low rates. Insurance companies that offered annuities at much higher rates at a guaranteed return are having difficulties if they did not fully hedge their liabilities.

It also means that anything that is annuity-like and has maintained its value is very valuable. To generate the age pension from an amount of capital takes a lot more capital than in the past. The age pension as an annuity stream is a lot more valuable in relative terms than 10 years ago.

The same goes with respect to annuities from private providers and defined benefit pension funds. Roger Gray from USS pension fund in the UK has calculated that to get the same retirement income in real terms as one did 25 years ago requires 10 times more capital. Conversely if you are an issuer of annuities you could lock in current rates and potentially benefit from any upside in terms of interest rates.

For retirees there will be greater drawing upon savings and the need to work longer, spend less and potentially greater reliance on the age pension. It may also mean greater use of things such as reverse mortgages to un-tap the wealth locked up in housing.

Low interest rates also mean the opportunity cost of having money tied up in non-income producing items (such as physical gold, bank notes or even land) is a lot less.

How can you take advantage?

Apart from taking advantage of the low rates for sensible borrowing, investors should look wider than traditional cash and bonds and consider high-yielding hybrids, defensive equities and other instruments that offer a higher yield.

In terms of equities, whilst certain higher-yielding stocks look attractive relative to bonds, one has to be careful of crowded trades and not taking on too much risk. As PIMCO (the largest bond manager in the world) says, we have now entered a 'new normal' and in many respects we are now in uncharted waters.

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