A week ahead of the next expected interest rate rise, Wealth Management principal at Picher Partners, Andrew Wilson, discusses how the landscape will change for leveraged investors, but why this isn’t time to panic.
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More than $650 million in loans were drawn down in April alone for the purpose of personal investment and that doesn’t include financing property.
Investors have enjoyed low interest rates across the last few years but now the cost of money is turning skywards. Indications are that the Reserve Bank is not yet finished hiking interest rates, and as lenders inevitably follow suit, the landscape will change for leveraged investors.
Rates going up should not mean hitting the panic button and ripping up investment plans, but it might mean tweaking the strategy to make sure your goals stay in view.
Start your review with remembering why you borrowed in the first place – to deliver on your unique investment objectives. Whether it’s planning for retirement or funding a project, your goals give direction and purpose to the financial plan.
Hurdles are not just for track athletes. The hurdle rate is a factor taken into consideration when borrowing for investment.
Let’s assume the cost of borrowing for investment purposes is 3%. With a salary in the top marginal income tax rate, the after-tax interest cost, or hurdle rate, is approximately 1.5%.
A borrowing to invest strategy is profitable, if the investment return exceeds the hurdle rate.
Over the last two years, the hurdle rate has been exceptionally low, around 1.5% to 2%. Most asset classes have exceeded that with ease and therefore investors have generated a profit.
As interest rates rise, that hurdle rate will start to get higher and more challenging to get over.
It is still plausible to clear a hurdle rate that reaches 4% or 5% if you’re investing in growth assets but an annual return below the hurdle rate will become more frequent and the strategy can oscillate more frequently between a gain and loss position.
Investors will need to be more selective about the assets they invest in and focus more on the cash flow of the gearing strategy.
A buffer is an amount added to the hurdle rate to allow for interest rate increases and unforeseen cash flow issues. It is prudent for investors to review what their cash flow would look like if interest rates increased by 1.5-2.5%.
If this extra interest cost is not manageable, investors can get ahead of the curve by reducing their gearing level before their financial position becomes too tight. Equally, you can re-assess whether borrowing is required at all to achieve your objectives.
If you can achieve your objectives without borrowing to invest, you may be taking unnecessary risk by implementing a gearing strategy.
Many investors have multiple debts – some deductible, some non-deductible. As a rule of thumb, it makes sense to repay your non-deductible debt sooner than your deductible debt, because a tax benefit can be claimed on the deductible debt.
Consolidating debt is a common strategy for investors with multiple loans. Consider refinancing higher-cost loans into your lowest-cost loan to reduce your overall interest cost. Noting that it is generally not recommended to consolidate deductible and non-deductible debt.
An offset or a redraw facility is also useful for borrowers. These allow investors to offset the interest costs incurred on the loan. For investors with a debt outstanding, it does not make sense to accrue cash in a bank account, earning a lower rate of interest, while incurring a higher rate of interest on outstanding debts.
Any income, including a salary, could be directed straight into the offset account, even if it only saves a week or two weeks of interest cost on a loan. When that’s compounded over a 10- or 20-year period, it makes an enormous difference.
Often people get frustrated that financial institutions won’t lend them large sums against a high-value asset. In the investor’s mind, the calculations make sense – they want to borrow $1 million and they have $2 million in assets to secure it against, so why doesn’t the bank provide the financing?
The bank needs an investor to have sufficient cash flow to repay the debt because that is the primary exit for a debt. Selling the asset to repay the loan is the backup strategy, not plan A.
Use this mindset when examining a personal gearing strategy by making sure you have enough cash flow to repay the debt, plus a margin of safety. If you’ve borrowed at 3%, borrowing costs of 5% should be factored in as a buffer against interest rate rises in the future.
If you are relying on selling assets to extinguish the debt at retirement, there is considerable timing risk in trying to sell the asset at a high point. For a portfolio of assets, consider gradually selling down over an extended period to average your exit price. Or, for single-asset strategies, such as real property, be prepared to be flexible on your sale date.
Being a forced seller when markets are down will be a painful experience.
There’s no doubt there are a few investors feeling edgy about what the future holds, with the rising cost of borrowing and concerns about growing their wealth.
As rates go up, use it as a catalyst for reviewing the investment plan, and factoring in the additional risk that comes with borrowing to invest. Take some time out to assess your position and make sensible adjustments but don’t lose sight of your goals.
About the author
After a decade working in two senior roles at Australia’s largest and longest-standing financial institutions, Andrew Wilson joined Pitcher Partners, working his way up to principal in a short time. He provides his clients counsel and guidance on all financial matters as part of an ongoing relationship, focusing on helping clients build sufficient passive investment income. Andrew’s expertise cover investment management, tax minimisation, debt management, asset protection, retirement planning and estate planning.
TORONTO – Strength in the base metal and technology sectors helped Canada’s main stock index gain almost 100 points on Friday, while U.S. stock markets climbed to their best week of the year.
“It’s been almost a complete opposite or retracement of what we saw last week,” said Philip Petursson, chief investment strategist at IG Wealth Management.
In New York, the Dow Jones industrial average was up 297.01 points at 41,393.78. The S&P 500 index was up 30.26 points at 5,626.02, while the Nasdaq composite was up 114.30 points at 17,683.98.
The S&P/TSX composite index closed up 93.51 points at 23,568.65.
While last week saw a “healthy” pullback on weaker economic data, this week investors appeared to be buying the dip and hoping the central bank “comes to the rescue,” said Petursson.
Next week, the U.S. Federal Reserve is widely expected to cut its key interest rate for the first time in several years after it significantly hiked it to fight inflation.
But the magnitude of that first cut has been the subject of debate, and the market appears split on whether the cut will be a quarter of a percentage point or a larger half-point reduction.
Petursson thinks it’s clear the smaller cut is coming. Economic data recently hasn’t been great, but it hasn’t been that bad either, he said — and inflation may have come down significantly, but it’s not defeated just yet.
“I think they’re going to be very steady,” he said, with one small cut at each of their three decisions scheduled for the rest of 2024, and more into 2025.
“I don’t think there’s a sense of urgency on the part of the Fed that they have to do something immediately.
A larger cut could also send the wrong message to the markets, added Petursson: that the Fed made a mistake in waiting this long to cut, or that it’s seeing concerning signs in the economy.
It would also be “counter to what they’ve signaled,” he said.
More important than the cut — other than the new tone it sets — will be what Fed chair Jerome Powell has to say, according to Petursson.
“That’s going to be more important than the size of the cut itself,” he said.
In Canada, where the central bank has already cut three times, Petursson expects two more before the year is through.
“Here, the labour situation is worse than what we see in the United States,” he said.
The Canadian dollar traded for 73.61 cents US compared with 73.58 cents US on Thursday.
The October crude oil contract was down 32 cents at US$68.65 per barrel and the October natural gas contract was down five cents at US$2.31 per mmBTU.
The December gold contract was up US$30.10 at US$2,610.70 an ounce and the December copper contract was up four cents US$4.24 a pound.
— With files from The Associated Press
This report by The Canadian Press was first published Sept. 13, 2024.
TORONTO – Canada’s main stock index was down more than 200 points in late-morning trading, weighed down by losses in the technology, base metal and energy sectors, while U.S. stock markets also fell.
The S&P/TSX composite index was down 239.24 points at 22,749.04.
In New York, the Dow Jones industrial average was down 312.36 points at 40,443.39. The S&P 500 index was down 80.94 points at 5,422.47, while the Nasdaq composite was down 380.17 points at 16,747.49.
The Canadian dollar traded for 73.80 cents US compared with 74.00 cents US on Thursday.
The October crude oil contract was down US$1.07 at US$68.08 per barrel and the October natural gas contract was up less than a penny at US$2.26 per mmBTU.
The December gold contract was down US$2.10 at US$2,541.00 an ounce and the December copper contract was down four cents at US$4.10 a pound.
This report by The Canadian Press was first published Sept. 6, 2024.
TORONTO – Canada’s main stock index was up more than 150 points in late-morning trading, helped by strength in technology, financial and energy stocks, while U.S. stock markets also pushed higher.
The S&P/TSX composite index was up 171.41 points at 23,298.39.
In New York, the Dow Jones industrial average was up 278.37 points at 41,369.79. The S&P 500 index was up 38.17 points at 5,630.35, while the Nasdaq composite was up 177.15 points at 17,733.18.
The Canadian dollar traded for 74.19 cents US compared with 74.23 cents US on Wednesday.
The October crude oil contract was up US$1.75 at US$76.27 per barrel and the October natural gas contract was up less than a penny at US$2.10 per mmBTU.
The December gold contract was up US$18.70 at US$2,556.50 an ounce and the December copper contract was down less than a penny at US$4.22 a pound.
This report by The Canadian Press was first published Aug. 29, 2024.
