Brent Sheather: Kiwis lucky as interest rates beat inflation

While short-term interest rates around most of the developed world seem stuck in the 0 to 2 per cent range, retired local investors who avoided the debenture trap have been relatively lucky as New Zealand's short-term rates have stayed well above inflation.

This favourable climate has permitted even those investors who kept their funds in the lowest-risk category, short-term bank deposits, to keep ahead of inflation.

In contrast, retired investors in the US, UK and Europe have been doing it tough for years - interest rates on short-term bank deposits and government bonds have been barely above zero per cent and well below inflation.

The only way to get a half-decent income over there has been to take on risk either by locking your money away for a longer term (10-year US government bonds yield around 3.5 per cent) and thereby incur interest rate risk, or by lending to less credit-worthy institutions (high-yield bonds yield 7.85 per cent) and incur substantial default risk.

This dire environment for savers has been manufactured by the US Federal Reserve's policy of keeping short-term interest rates low. However, the days of the low-interest environment overseas may be numbered, according to a report by the McKinsey Global Institute (MGI), entitled "Farewell to Cheap Capital". McKinsey and Co, a leading management consulting firm, says MGI research is "independent and has not been sponsored in any way".

So what, if any, implications does it have for New Zealand investors?

The report's main conclusion is, predictably, that interest rates around the world are going to go up. US government bond yields that hover around 2 per cent today were more than 9 per cent in the early 1980s. MGI reckons the decline is because the rate of investment in mature economies has fallen significantly since 1970.

But that is about to change - the world is now about to embark on an enormous wave of capital spending driven primarily by emerging markets. Investment areas will include infrastructure spending and houses. MGI argues that global savings rates will increase in response to this, but at nowhere near the same rate as investment increases, putting "sustained pressure on real interest rates".

Let's put some numbers on these. US 10-year government bonds are at 30-year lows in both nominal and inflation-adjusted terms - 3.5 per cent and, assuming OECD forecasts for inflation, 1.7 per cent respectively.

If real rates were to return to their 40-year average of 3.3 per cent, real US 10-year bond yields would rise by about 1.5 per cent. That's bad news for anyone who owns long-dated bond. But the forecast deficit between investment and savings is such that real rates could well rise beyond their 40-year average.

Real rates since 1870 have been as high as 4.3 per cent for sustained periods; for example, in the 12 years from 1987 to 1999. MGI forecasts that US 10-year bond yields could start rising within the next five years as investors begin to anticipate the "end of cheap capital".

So what could a 1.5 per cent increase in real US 10-year bond yields mean for mum and dad, retired and living in Te Kauwhata?

For a start, US 10-year bond yields are something of a benchmark for the global interest rate market and, if they rose by 1.5 per cent in real terms, the odds are rates in Europe and around the world would be similarly upwardly mobile.

The average New Zealand managed retirement fund has about 20 per cent of its assets allocated to overseas bonds and the effect of a 1.5 per cent increase in the interest rate of 10-year US bonds would mean a fall in price of around 11 per cent. Eek.

But that is just the start. Higher interest rates are frequently associated with lower share prices, as price/earnings ratios fall. Ditto for the property market. So in percentage terms, a rise in overseas interest rates might have an even greater effect on overseas share/property markets.

What about us in New Zealand, and specifically the New Zealand bond market? Are our real yields low on an historic basis, too?

In the last 40 years, New Zealand 10-year government bonds have been volatile - as high as 18.9 per cent in March 1986 and as low as 4.25 per cent in January 2009, with an average yield of 8.8 per cent. In the same 40-year period New Zealand inflation has averaged 5.9 per cent, so that means the average real interest rate over the past 40 years has been 2.9 per cent.

Today, 10-year NZ government bond yields are 5.5 per cent and Westpac institutional bank's 10-year CPI forecast is 2.65 per cent a year. If Westpac's forecast is correct, today New Zealand's 10-year bond rate offers a 2.85 per cent real return, virtually spot on its 40-year average.

Given this fact it appears that New Zealand interest rates are unlikely to rise as much as those in the US and the rest of the developed world although, of course, there is likely to be some spillover effect if US interest rates go through the roof.

One other conclusion of the MGI study that has particular relevance for Kiwis and our Government is that "mature market governments need to find ways of promoting more saving, rebalancing their economies so they depend less on consumption to fuel growth ... Policy makers should put in place mechanisms to raise household savings".

One of the biggest disincentives to adopting a prudent savings strategy in New Zealand is Dr Michael Cullen's ridiculous fair-dividend-rate tax on overseas shares. This tax assumes overseas shares earn a dividend of 5 per cent and are taxed on that amount when, in fact, the average yield on overseas shares before fees is barely 2.5 per cent. The FDR tax is a major disincentive to savings, and may even encourage consumption rather than saving. The Cullen tax must go.

Lastly, some good news. Higher bond yields mean higher interest income for newly retired investors and ultimately for existing investors, as when bonds mature they will be reinvested at higher yields. So it's not all gloom and doom. And for that matter, it might not even happen.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.