What Low Interest Rates Mean for Investors

April 06, 2020

In the wake of the 2008 financial crisis, strong actions were warranted by the Central Bank and US government. One of these actions was a swift drop of the Federal Funds rate to 0%. This FOMC (Federal Open Market Committee) target rate ran for close to six years as the global economy and financial system restored its strength. After a timid rate-hiking cycle and a new once-in-a-lifetime event, we now find ourselves back at the 0% target. What does this mean for the economy and investors?

While the Fed was certainly wise to lower interest rates in response to the COVID-19 outbreak, the rate cut had minimal effect. First, interest rates were already low. Given the deteriorating credit quality of companies and individuals, borrowing costs have actually increased. The additional compensation required to lend in a time of crisis outweighs the 1.5% cut the Fed had to offer. Another limitation to lower interest rates is that no level of interest rates, even 0%, will spur demand for goods and services as long as citizens are under quarantine. The combination of these factors requires the economy to repay significant liabilities with little flexibility to refinance debt obligations at lower rates.

Assuming the US does not venture into the unknown territory of negative interest rates, the Fed has already exhausted one of its primary tools to manipulate the economy. As a result, the Central Bank has now engaged in large-scale asset purchases that include treasuries, mortgage-backed securities, corporate debt, and short-term municipal debt. This program injects money into the economy and keeps interest rates low across all maturities. As long as the FED continues to expand its balance sheet, expect interest rates for both short- and long-term debt to stay firmly lower. These monetary and fiscal efforts rival the deficit financing of World War II with estimates of a deficit north of 20% of GDP. While such an effort can weigh on the economy, an intelligent balance of taxes, borrowing, and money printing can smooth the recovery through the next economic expansion. We view this economic event as a temporary and intentional response to the COVID-19 outbreak. With no structural damage to the US economy, a strong economic rebound can quickly offset much of the damage incurred over this time.

What do these persistently low rates mean for fixed-income investors? With government rates (the riskā€‘free rate) at such low levels, returns have become increasingly dependent on credit spreads. Rigorous analysis of company financials can navigate investors to reliable returns while avoiding unnecessary risk. We prefer established entities with strong balance sheets, conservative financial management, and robust liquidity. A taxable investor can look to the municipal market to diversify risks, maintain credit quality, and find attractive tax-equivalent yields. While low interest rates have a very visible effect on bond yields, it is important to remember that they influence all asset classes. Asset allocations for both institutional and retail investors will likely respond to the new environment. In a universe of low-yielding investments, market participants tend to gravitate to the chance of higher-equity returns. For some institutional investors such as pension funds, increasing exposure to risky assets is now the only hope of reaching their long-term investment targets that often exceed 7%. For individuals, the current environment requires a more thoughtful process of managing risk and return.

Stay diversified. This pandemic is a reminder that no one can predict exactly what the future holds. Spreading investments across sectors, themes, and asset classes continues to be the cornerstone of prudent portfolio management and long-term investment success.

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