Everyone is disenchanted with the low rates of interest being paid on bank deposits and income funds. The days of being able to put your money in a principal-protected investment for one year at six per cent are but a fading distant memory. We have all watched helplessly as returns on traditional short-term investment products gradually declined over the last decade (see Figure 1). Last year when rates fell to two per cent for most income funds we all thought it could not go lower: returns are now below 1.50 per cent!
A low interest rate environment is one of the most difficult for investors to negotiate and it is easy for frustration with such low returns to force investors into products that may lead to losses later on. To make the right decisions in such a situation we need to "understand the lay of the land". In most instances interest rates are low when there is too much liquidity (in the form of cash balances at the banks) and insufficient investment opportunities. Usually the economy is stagnant or declining, inflation has ebbed and monetary policy is geared to reducing interest rates across the entire yield curve to encourage borrowing and spending. One needs to keep an eye on the state of the economy to assess whether interest rates are likely to move higher.
Short-term investment products are the most responsive to interest rate changes and are the first to experience lower returns as interest rates fall. These include bank deposits and income funds. The yield on bonds also decline and this is reflected in a higher price for previously issued bonds trading in the secondary market. The holders of these bonds could realise a capital gain while new investors buying these bonds would be paying a higher price. On the other hand, shares trading on the stock exchange tend to show mixed performance. Shares of those companies that are heavily dependent on the state of the economy usually fall in value in line with the slowing economy. Those companies whose businesses are not significantly tied to or impacted by economic swings and that also pay high dividends tend to experience an appreciation of their stock price. Concurrently real estate prices may rise as more investors seek returns in this market as lower interest rates reduce the overall carrying cost for an investment property.
As you contemplate investment options, you need to keep an eye on the direction of interest rates for the short-to-medium term (one to five years). If there is a reasonable chance of rates rising, the best strategy is to remain in short-term investments where you can access your money to take advantage of higher rates. Also, as interest rates rise, fixed income products such as bonds fall in value. My assessment of interest rates at this time is that given the continued sluggish economy and high government spending, excess liquidity will keep TT Dollar interest rates subdued at least for the balance of 2012 and for the most part of 2013. Having said that, we should also recognise that current interest rates are at historic lows and a return to normal levels (rise in rates) is likely to occur in the medium term.
So where should you put your money? The answer is in a mix of investments. Despite the low interest rates, a portion should be in short-term investments such as income funds that guarantee return of principal. At this time you need to be careful with flexible NAV (net asset value) income funds as the price of these funds move with bond prices. You can earn a higher return on these flexible NAV income funds if interest rates continue to fall (although there is not much room to go lower) but will experience a fall in fund value when interest rates rise (the underlying bond prices will fall).
There is a dearth of opportunities in the TT Dollar bond market at this time but if you are offered bond investments, you should keep such investments to terms of less than five years. As previously noted, interest rates will normalise in the medium-term so sticking to shorter-dated bonds would provide the ability to reinvest at higher rates when these investments mature. For example, purchasing 10, 15 or 20-year bonds at this time, will leave you stuck with a low interest-paying bond for a relatively long time and if there was an immediate need for liquidity, the case of an emergency for example, you may have to sell such a bond at a much lower price.
Local equities are more difficult to call as individual stocks vary in potential returns. Preference should be given to stable, non-cyclical companies that pay an attractive dividend (over three per cent yield). By holding such investments you will receive periodic cash flows with the potential to generate capital gains when the market recovers. There are a few stocks that meet this criterion but they are hard to come by as there are few sellers and many buyers.
At a time like this, investors should consider expanding their investment universe beyond Trinidad and Tobago. There is a variety of investment opportunities in US Dollars (and other currencies) and any of SDATT's member-companies can provide local investors with access to these investments. US dollar interest rates are also at historic lows but an experienced and knowledgeable investment adviser would be able to recommend investment grade bonds denominated in US Dollars yielding a return above five per cent at a relatively short maturity. In addition, global equities as an asset class should be a part of any investment portfolio for any local investor (with the appropriate risk tolerance level assessed and measured). Global Equities provide diversification as it is not highly correlated with other asset classes (for example local equities, bonds and short-term investments) and will contribute to reducing portfolio risk and therefore improving risk-adjusted returns. Investors in international equity markets also benefit from high trading liquidity and potentially higher returns in markets that are experiencing relatively robust economic growth.
In conclusion, my advice to investors in this environment is to exercise caution when selecting interest rate sensitive investments and expand their horizon to other currencies and markets that provide diversification, lower risk and potentially higher returns. In addition, take the time to understand the investments you are selecting. Ask about the potential returns, the risks involved and the liquidity (how easy is it to buy or sell) as this will save you from unpleasant surprises later on.
Ramcharan Kalicharan is a member of the Board of Directors of the Securities Dealers Association of Trinidad and Tobago.