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Interest rates - what do they affect?
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Interest rates - what do they affect?

created Forex ClubJune 15 2021

In recent years, we have witnessed events that are unmatched in modern economic history. The ultra-loose policy of central banks as it was combining low interest rates and carrying out QE (quantitative easing) programs caused the appearance of a number of phenomena that were not encountered even 20 years ago in the United States and Western Europe.

Interest rates and the real estate market

Low interest rates facilitated access to loans, both for individual customers and enterprises. As could be expected, some of the funds "hit" the real estate market. Since the cost of financing in many countries is extremely low, and the interest rates on bonds and bank deposits have dropped, more and more funds have fled from the deposits and went to the real estate market. The combination of these two factors made real estate prices in major Polish cities soar. 

The situation is similar in other European markets, such as Denmark, where the price of housing increased by 2020% in Q3 2,4 (XNUMX% of the real price increase). In Denmark, they are offered 20-year housing loans with a fixed interest rate of ... 0%. This type of loan was offered by Nordea Bank in January 2021. However, it should be remembered that low interest rates alone do not guarantee an increase in home prices. They are only one of the "supporting" factors, which are also: real wage growth, low unemployment, demographics and government projects.

Lower rates are just one variable that will drive property prices up. Here, too, the rate cut itself will not significantly increase long-term price increases. This is due to the fact that the main “engine” of the demand for new housing is the population aged 25-40. Therefore, an important factor in the real estate market, apart from interest rates (the derivative is the cost of a loan), is the wealthier society and a favorable demographic situation.

As can be seen after the period of slowdown in prices in 2007-2011, real estate prices in the United States returned to dynamic growth.

00 interest rates 

Falling rates and corporate indebtedness

This is the best known effect of falling market interest rates. If rates are falling, borrowers can refinance their debt more cheaply. If the debtor has such a right, it is very common practice to buy back bonds and issue new ones at a lower interest rate. Thanks to this, the company can save on financial costs or extend the repayment date without increasing the interest rate on the debt. An example would be Amazon, which issued 40-year bonds (maturing in 2061) with a coupon of 3,25%. On the other hand, 2-year bonds currently have an interest rate of 0,25%.

Another effect of the decline in market interest rates is the rise in bond prices. This is because investors are looking for the highest possible rate of return for their bond portfolio. For this reason, a drop in interest rates means that those who have free funds prefer to buy bonds with a higher fixed coupon than a lower one (with the same investment risk). As a result, YTM (yield-to-maturity) rates are equal to higher interest rates through the increase in the price of bonds (decrease in profitability).

Another effect of the long persistence of low interest rates was the "incentive" of boards of publicly traded companies to run "generous" shareholder programs. Many companies gave more money to shareholders (through dividends and share buyers) than they were able to generate free cash flow (FCF). This resulted in an increase in borrowing needs that were aimed at financing these programs. The management boards realized that they could issue a lot of bonds with a very low yield, so that financial costs would not weigh on results too much. As a result, the share price of many companies "was" also fueled by the generosity of company management boards. An example is McDonald's, which in 2015-2019 paid out: over $ 32 billion in the form of share buyouts and $ 16,2 billion in the form of dividends. At the same time, FCF amounted to approximately 22,6 billion free cash flow. Most of the funds were obtained by the company through debt issuance. At the end of 2014, the company had $ 14 billion in long-term debt, and over the next 5 years, the interest debt increased to over $ 34 billion (leasing was omitted).


Check it out: How to invest in contracts for treasury bonds [Guide]


The downside of a low interest rate environment is that firms are "habituated" to a low cost of credit. As a result, some ineffective enterprises are not "motivated" to increase operational efficiency because they do not feel pressure from lenders. The surplus of available capital means that even weak companies can find financing. This creates zombie companies. For the first time, this type of company was observed in Japan after the bursting of the real estate bubble (late 80s and early 90s). However, companies of this type also appear in the European Union and the United States. In the United States, as a result of the economic closure, the indebtedness of this type of companies increased. It amounted to $ 2020 billion at the end of 1, which was three times the amount reported in 400. 

Yield hunting 

Central bank policy contributed to a drastic drop in bond yields. Safe bonds of countries such as Germany, France and Denmark had very low yields. In many cases, bond yields are negative. According to Bloomberg Barclays Global Negative Yielding Debt Index in December 2020, bonds with negative yields were over $ 18 billion. According to Bloomberg, at that time around 000% of investment-grade bonds had a yield below 27. This is not surprising as PEPP is still operating (Pandemic Emergency Purchase Program), the volume of which was $ 1 billion. Under this program, the European Central Bank can purchase both private and government debt. 

Since it is increasingly difficult to obtain a satisfactory yield on bonds in the bond market with a high investment rating, the phenomenon of "Hunting for profitability". As a result, there is a group of investors who, in search of bonds with a higher yield, want to invest in bonds with a higher risk. As a result, some companies and countries with a very low credit rating do not have problems with rolling their debts at lower profitability.

An example is Argentina, which 3 years after technical bankruptcy (2014) issued a 100-year debt with an interest rate of 7,1% worth about $ 2,7 billion. 

More and more funds go to the bond market with a speculative rating (below BBB / Baa3). This type of bond is also often called "Junk". In February 2021, the yield on American bonds of this type fell below 4%. Never before in history (since this type of data is collected) has a junk bond yield been so low.

Increased popularity of alternative investments

Another problem caused by the low interest rate policy was the need to look for other asset classes. As a result, more and more institutional clients were looking for a "third asset class" (other than the stock market and bonds). This has led to a significant increase in the popularity of alternative investments. This asset class includes, inter alia, real estate investments (e.g. telecommunications faiths, data centers, critical infrastructure), PE funds, leveraged loans, or alternative credit products. Among the clients using professional companies focusing on this type of investments, there are: university funds, insurers, pension funds or government funds (Sovereign Investment Fund).

According to data provided by BAM (Brookfield Asset Management) in 2000, only 5% of assets were invested in alternative investments. In 2017, the share of this asset class increased to around 25%. If past trends continue, alternative investments will account for approximately 40% of assets under management in 2030. The companies operating in this market, which are listed on the stock exchanges: Blackstone, KKR or BAM, also use global trends.

Stock market - valuations and property effect

"Książkowo", a drop in interest rates should increase the valuation of listed companies. This is due to the fact that investors in such an environment expect a lower rate of return on stocks. This in turn makes them willing to accept higher stock prices in some situations (the risk premium does not increase). It occurs then "Stock market multiplier effect", when good-quality companies grow faster than it results from the company's foundations (including increase in revenues, profits, FCF). As a result, the "multiplier" at which the company is traded increases.

02 Interest Rates

Source: Robert Schiller

A fall in the interest rate does not increase the multipliers in a linear manner. This is just one of the conditions that can help increase company valuations. However, it should be remembered that low interest rates alone will not create a bull market if companies are not able to generate more income and profits in the long term. The effect of lower interest rates is short-lived, because a change in the multipliers (their increase) with each successive year has a smaller impact on a change in the valuation.

Higher stock valuations translate into so-called "Property effect". This phenomenon has been observed in the United States. It is where the increase in asset valuations made households feel "wealthy", which translated into increased consumption. This contributed to a positive impact on the Gross Domestic Product. However, in countries with a small share of equities in household assets (eg Poland), the wealth effect is imperceptible from the macro level.

Low rates - banks

For banks, the low interest rate environment is not favorable. This is due to the fact that low market rates of return contribute to the erosion of net interest income, which reduces the return on equity of the banking sector. Why does a drop in the interest rate reduce the net interest income of the banking sector? 

Over the past few years, the main rate National Bank of Poland fell from 3,5% to just 0,1%. This resulted in a decrease in the profitability of loans (depending, for example, on the WIBOR rate, which does not deviate too much from the NBP rate), which lowered the interest income of banks. At the same time, the decline in interest rates on deposits was not symmetrical in relation to the reduction in interest rates on loans. As a result, interest costs fell slower than revenues (it is difficult to convince clients to interest on deposits below 0 😊 ). This, in turn, hit the net interest income. The banking sector in Europe also has to cope with the increased regulatory environment, pressure from fintechs and risk management for non-performing loans (NPLs). Due to these factors, the return on equity of the European banking sector is very low. In 2019, the ROE of the Polish banking sector was below 7%, which was an average result compared to other banking sectors in the European Union countries.

Mergers, acquisitions, financing

The low cost of debt financing and the available capital of investors who are looking for a satisfactory rate of return make it a favorable situation for the mergers and acquisitions (M&A) market. According to data prepared by the Institute for Mergers, Acquisitions and Alliances (IMAA), the global value of mergers and acquisitions in 2019 amounted to $ 3,37 trillion and less than 50 transactions of this type were carried out. In 000, there was some slowdown in mergers due to the uncertain economic situation caused by the SARS Cov-2020 virus. 

04 Merger & Acquisition interest rates

Source: IMAA

Surprisingly, the ultra-low interest rates and expansionary monetary policy of central banks did not contribute to the "jump" increase in the value of mergers and acquisitions around the world. According to IMAA analyzes, 2007 was exceptional, when M&A was closed for nearly $ 5 trillion. 

Another effect created by the environment of easy access to capital is the higher valuation of technology companies. The multipliers for technology companies at the level of 20 times the revenues achieved are no surprise to anyone. An example is the Singapore company Grab (including transport services, food delivery), which in August 2020 was valued at about $ 14 billion, in April 2021 the valuation increased to over $ 40 billion. It's worth noting that 2020 revenues were $ 1,6 billion with a net loss of $ 2,7 billion. The ease of raising capital means that many companies can focus on growing, and not on quickly achieving profitability. 

Interest rates: Summary

The low interest rate environment and the application of quantitative easing create favorable conditions for the growth of many asset classes. Low rates support the real estate market from two directions. 

First, there is a "substitution" effect. This is due to the fact that low interest rates lower the profitability of investments and safe bonds. This, in turn, means that some of the funds go to the real estate market for investment purposes. Secondly, cheap credit increases the demand for residential real estate.

The low interest rate environment supports the valuation of companies, both listed on stock exchanges and in the private market. Another effect is lower profitability of the banking sector and increased interest in alternative investments.

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