Why low interest rates are hurting investors of all stripes

Low interest rates encourage excessive risk taking

T“When you combine ignorance and leverage, you get some pretty interesting results.”

Warren Buffett

here is a lot to be said for low interest rates: The majority of global equity markets have recovered and many are testing new highs; global bond markets have sent yields to new lows; and U.S. housing prices have bounced back nicely, while the Canadian housing market has made a fool of all the doomsayers by continuing to push to record highs.

Rates have remained low for so long that it has almost become the new normal. I remember listening in disbelief when my parents talked about the high double-digit interest rates back in the 1980s and I now wonder if my kids will think the same when I tell them about interest rates being at a whopping 5% 10 years ago.

The problem is that low interest rates leave investors feeling rather comfortable in doing things they normally would not do and they encourage excessive risk taking.

Some articles are pointing out that people in Calgary are investing in the equity markets and expecting to get a conservative 7% or more annual return simply because they have done much better than that in the past few years.

Why pay down that 3% mortgage when you can take out some low-cost margin and double-down on one’s investment in the equity markets?

We are also seeing growth in the number of interestonly lines of credit being used to purchase million-dollar homes with the following rationale: “I can buy such a home with a $300,000 down payment and the interest is only $2,375 a month. Essentially, I get to live in a mansion for the same monthly cost as renting a modest apartment.”

But, hey, they’re low-risk mortgages because of the 75% loan-to-value ratio.

Low interest rates are also causing quite a bit of trouble for retiring Baby Boomers who would normally start to de-risk their investment portfolios. Instead, many are increasing the duration of their bond portfolios to chase every basis point they can get without realizing the risks.

Shorter-term global government bond yields are approaching near zero and even negative in some countries, so bond investors have had little choice but to move up the duration ladder in search of yield.

Although such bonds may seem like a safer investment (being government and “risk free”) and they have been a great trade during the past couple of years, investors are ultimately facing greater hidden risks in the future, especially if interest rates do something crazy, such as increase.

All else being equal, the higher the duration, the higher the sensitivity to rate changes, which means the higher potential price change in the underlying bond. For a bond with a duration of 20 years, a 1% increase in interest rates would mean a whopping 20% drop in the bond’s price.

Even worse, investors have been piling into high-yield, otherwise known as junk bonds, at the fastest pace since the financial crisis in 2008.

In total, US$12.2 billion has flowed into U.S. junk-focused bond funds this year, according to Bank of America Merrill Lynch and as cited by CNBC. It may be hard not to blame investors since the average yield is more than 6%.

Finally, investors are also replacing their bond portfolio with equity instruments such as REITs and preferred shares because of their enticing dividend yields, often more than 4% on average.

Demand last year was so strong that we heard REITs and preferred shares accounted for up to one-quarter of stockbroker client portfolios in Canada.

Perhaps this is why retail advisers panic-sold REITs in the fall of 2013 because of worries about interest rate hikes and, more recently, oversold the preferred share market (rate resets) on the recent Bank of Canada rate cut.

We’re not suggesting investors stay away from using tax-efficient leverage when investing or shun high-yield or long-duration bonds. But they should at least recognize the merits of moderation and proper asset allocation.

It is always important to do your homework and measure the specific risks that you are taking against the potential rewards.