29 April, 2011 15:13

Velele Nkosi

Investor Zone

Interest Rates - the link to your portfolio

The cost of credit is commonly known as interest rates. For the first time in years both in South Africa and globally interest rates are at their all-time lows.

This has been good news for most especially consumers as we rejoice at the impact lower interest rates have on debt.

Lower interest rates make borrowing cheap; for household lower interest rates encourage spending. For business lower interest rates mean an opportunity to expand i.e. to finance purchases of machinery, equipment and buildings. An example of this is the latest announcement made by Nedbank saying that it had assisted Netcare to raise R1.2 billion in the debt capital market.

Increased spending is good for the overall economy because when consumers buy more, businesses grow and they hire more workers. As good as that may be increased spending is inflationary, inflation being the general rise in the price of goods and services.

To understand the impact interest rate has on your portfolio we need to define the types of interest rates i.e. the repurchase rate, bank rate and the prime rate.

The repurchase (REPO) rate is defined as "the rate at which our banks borrow currency from the central bank; the bank rate or discounted rate is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries, whereas the reference rate or prime rate is the interest rate charged by banks to their customers".
 

The monetary policy committee through the South African Reserve Bank (SARB) uses the repo rate as one of the tools to keep inflation in check.

Even though inflation is not the only factor considered to adjust interest rates however it is likely that if inflation were to increase outside the defined parameters the SARB will hike interest rate.

Banks tend to follow suit increasing interest rates on home, car and personal loans. As credit becomes expensive it affects the purchasing power of households and business alike.

As companies do a projection each year of their expected income and expenses when interest rates rise, debt expense increases.

The expense pool outpaces income thereby reducing the net profit. Consequently then shrinking profit reduces the return on investment to shareholders. If profit margins are low sometimes JSE listed companies will opt to withhold the dividend payment.

The effect of interest rate changes has a direct bearing on the financial and property sectors. When there is an expectation of a change in interest rates the financial sector is usually volatile a week or so before the Central/Reserve bank make an announcement on the changes in interest rate.

The reason for all the movement in the financial markets is because of the investors positioning themselves to take advantage of projected interest moves by either buying or selling financial stocks. The next interest rate announcement is scheduled for the 12th of May 2011.

On the day of announcement if interest rates outcome deviates from market expectation especially if it is an increase most sectors are likely to decline for the reasons mentioned above.

The impact of higher interest rates in the property sector is twofold i.e. it reduces demand for property due to the increased cost of debt. Lower home demand and constant or increased supply leads to lower property prices.

The second effect is heightens appeal of the rental market, because more people will opt to rent than to own property.

Most local economists have predicted that interest rates will increase sometime this year in South Africa. China has been increasing interest rates since last year to curb inflation and recently the European Central Bank.

A prudent investor will factor this in when choosing stocks to include in his portfolio. He will be wise to visit the debt holding or liabilities and term of debt of the company in the balance sheet.

*Velele is a stockbroker at BJM Securities. While most of her day is spent watching the movement of share prices and the current affairs of the markets, she has a passion for helping the broader population understand the markets so that they can invest with success. This column aims to inform and educate people who want to invest with skill and confidence.