Low interest rates, along with all their advantages and pitfalls, have defined much of the last decade. While prior recessionary periods have seen overnight shifts by the central bank to sub-1% interest rates, 2020 appears to manifest an extreme version of it so far. As the Federal Funds Rate was slashed from 1.5% to nearly 0% in March of 2020, the 10-year Treasury, the widely followed proxy for long-term rate setting purposes, registered a low of just 52 basis points within days of the Fed actions, an historic low.
The 30-year mortgage rates followed suit, dropping to 3.5% and then eventually to below 3% by July. The last time it came this close was in the 2012-2013 period, and even then, it remained persistently above 3.4%.
Not unlike other contractionary periods, these low rates provide an opportunity to strengthen balance sheets for both individuals and corporations alike.
Here are four things you may want to consider when interest rates are low (like right now).
1. Refinance your mortgage.
For illustration purposes, a $200,000 balance on a 30-year mortgage at 4% amortizes at approximately $960 per month. The same mortgage refinanced at 3% costs $850 per month. A pricey closing cost of $3,000 on average may be recovered within 30 months of the mortgage duration. Those who are under 20% of the mortgage/income ratio may be advised to consider a 15-year loan, hovering around 2.5% and reduce total interest paid by about $100,000 over the life of the loan. Since the 2017 tax law has been in effect, mortgage interest expense deduction has been a thing of the past for non-jumbo loans. This hidden cost of the tax legislation may be offset greatly through a 15-year loan.
2. Consider TIPS or inflation adjusted Treasuries.
With rates close to historic lows, “reversion to mean” conversations are rampant. In other words, all things will eventually revert to normal. So, it is not irrational to look forward and assume that rates cannot stay here forever and that they will “normalize” sooner rather than later. More importantly, while a slow recovery may keep rates lower for longer, the unprecedented nature of increased money supply in the economy should drive inflation in subsequent years, the operative word being should and not will. Depending on a long-term horizon and normalized rates, inflation adjusted Treasuries, or TIPS, may be suitable for those who are planning to benefit from reversion to mean inflation levels. Those interested in the TIPS trade must take into account that long-term US Treasuries have a deep pocketed buyer in the Federal Reserve this year and there may be risks to buying any fixed-rate security under these conditions even though TIPS are principal-protected.
3. Diversify with adjustable-rate preferred stocks to bridge income needs.
As an alternative to fixed-rate investments, adjustable-rate preferred stocks of investment grade companies may be a bridge to sustaining portfolio income while one waits for rates to normalize. While preferred stocks may be rich in dividend yields, investing in them is not a long-term substitute for true fixed income and shouldn't be seen as such. Some preferred stocks may be far more volatile than the common stock of the same company. While bond prices are negatively correlated to interest rates, adjustable-rate preferreds, especially those trading below par value, can be a viable, albeit temporary, substitute for bonds in a low interest rate environment. (Disclaimer: Preferred stocks have long-term maturities and/or call dates and may be quite illiquid during chaotic market conditions.)
4. Take advantage of affordable financing to purchase rental property.
Recessions tend to usher in a robust shopping season for budding landlords. This could be a great opportunity for those simply planning for possible supplemental rental income as financing becomes affordable and property supply exceeds demand. Residential properties are not following the standard recessionary demand lull this time, but opportunities in commercial real estate could be around the corner. Lease renewals amidst low demand may spur attractively priced listings for the right business owners looking to take advantage of current rates. Businesses with predictable cash flows may consider real estate ownership over long-term lease commitments.
Why Low Interest Rates Are an Opportunity for Wealth Creation
There has been a dramatic increase in the money supply along with the subdued interest rates in the US economy in 2020. How quickly and soundly the recovery takes hold will be dependent on our ability to put available capital to productive uses that create lasting opportunities for investors and consumers alike.
Interest rate cycles play a large role in wealth creation. If you missed the 2008 cycle, here is another chance!
About Our Author Shams Afzal
Shams Afzal is Managing Director and Portfolio Manager at Carnegie Investment Counsel’s Toledo office. A passionate and solutions-focused professional, Shams is dedicated to the total well-being and success of his clients. Shams also brings to Carnegie a unique perspective on risk management and material deficiencies sometimes obscured in public financial statements.
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The information herein was obtained from various sources. Carnegie Investment Counsel deems the information to be reliable as of the date indicated (or of publication). This is prepared for informational purposes only. The opinions presented are subject to change without notice in reaction to shifting market conditions. Past performance is not a guarantee of future results.