Issues for investors

• Replacing ‘lost’ income
• Preserving capital
• Maintaining liquidity
• Participating in growth opportunities
• Dealing with a trusted organisation  

Interest rates defined

An interest rate is the compensation received by the lender (or depositor) who has extended the use of their funds to others. Interest rates are usually expressed as a pre-tax percentage return over a one year period. Interest income (from most sources available to NZ investors) has tax deducted at the source in the form of ‘withholding tax’. In some cases, the PIE tax regime provides some investors with a tax advantage by ensuring that tax is paid at no higher than the individual’s personal rate and is capped at a maximum rate of 30%.

The nominal interest rate is made up of several components, which together add up to the prevailing rate:

• The risk-free cost of capital
• Inflationary expectations
• The risk of the borrower defaulting
• Transaction costs
• A liquidity premium

For these reasons, the interest return on the most secure investments such as government notes and bonds and bank deposits, typically offer the lowest rates. As the risk of default rises, so does the rate of interest, which is why corporate notes and bonds and finance company debentures offer progressively higher rates, in order to pay investors for the additional risk they are taking.

One of the challenges for investors is to find a rate they can accept for a given level of risk and to ensure that the rate adequately compensates them for the risk being incurred. Shortly after 2000, when finance company rates were priced as little as 2% over the equivalent term bank deposit rate, Spicers considered investors were taking on too much risk for too little return. Spicers research team issued such a warning to investors back in 2002 and subsequently did not recommend investment in any of the finance companies which have since failed.

How ‘the economy’ influences interest rates

The health of the economy has a major impact on the level of interest rates. When economic growth is strong, businesses are doing well and people feel good about their employment prospects, borrowers will be willing to pay higher rates. It is during times of prosperity that central banks tend to raise official rates to slow down the pace of economic expansion in order to prevent inflation accelerating.

Inherent within the risk premium which makes up an interest rate is a margin for inflation expectations. In the current environment where inflation is low but is expected to be higher in future years, short-term deposit interest rates will typically be much lower than longer term rates, and floating mortgage rates will be lower than fixed rates.

During times of low economic growth or recession, short-term interest rates are low in order to stimulate borrowing and reduce the interest burden on those with existing debts so their discretionary income is not critically reduced. During such times, those with interest bearing deposits face a significant reduction in income and bond holders face the risk of reinvesting at low rates upon maturity.

Outlook

Interest rates in New Zealand have fallen by around 6% over the last year as the Reserve Bank moved in step with other jurisdictions, to reduce short-term official rates in order to cushion the pain of firstly the financial crisis and now the economic slump.

There is potential for the Reserve Bank’s official cash rate (OCR) to head lower still over the course of the year. With a sluggish global trade outlook, unemployment picked to go higher and a still listless property market, planning for a continuation of low interest rates in 2009 seems a fairly safe assumption.

Financial planning

The importance of quality planning to help ensure that your future goals and objectives are achieved, has perhaps never been more essential at a time when the world faces an aging population and governments will be stretched to maintain their current pension burdens. Talk to a Spicers adviser today about the essential things you need to consider to give you peace of mind about your financial future.