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Last week the Bank of England increased the base rate from 0.5% to 0.75%. The decision was widely expected by both the market and commentators, given that the economic data published, so far, for the second quarter of 2018 showed marked improvements. The question now lies as to when the BoE will raise rates again given its comments on following a slow and steady path to hiking?
Most analysts expect further increases. The market expects interest rates to hit 1 per cent by Q4 2018, 1.25 per cent by Q2 2019 and 2 per cent by Q3 2020. This increase is likely to be welcome news for savers, although there’s considerable scepticism amongst experts that the full rate rise will be passed. By contrast most experts expect mortgage rates to rise almost immediately. Funny that!
4 ways the interest rate rise might work against you
The base rate also impacts the following investment areas: currency, bond yields, as well as the rate on deposits and borrowings of cash. Whilst the increase in discount rates also impacts the discount rates that many professional investors will use to value assets, we’ll omit this from the discussion. Let’s take each of these in turn:
According to MoneyFacts “almost a decade ago, the average easy access account paid 1.19 per cent, whereas now it pays just 0.53 per cent. And the average one-year fixed rate bond currently pays 1.34 per cent, some 1.60 per cent lower than back in 2009”.
MoneyFacts most recent update on top paying notice savings accounts reported that challenger banks topped the list – Oak North provided a 120 day notice account which paid 1.78 per cent, closely followed by Secure Trust at 1.75 per cent and Paragon Bank at 1.66 per cent. By comparison many lending platforms can offer in excess of 3 per cent per annum in income. Goji’s 1 year Direct Lending Bond has been yielding in excess of 5% since January 2017.
Across the UK, 9.1 million households have a mortgage and of these, more than 3.5 million are on a standard variable rate or a tracker rate. These people are most most affected by an increase in rates as their monthly payments would increase. The relatively small rise announced on Thursday will not be particularly painful for the vast majority of householders; the average outstanding balance is £112,000. For somebody with 20 years left on their mortgage, the monthly bill rise by about £14 a month, although debt charities say that some squeezed families will find this extra burden a real challenge.
Some rates may rise on other types of borrowing such as personal loans and credit cards. Whilst the personal loan market will see a rise in rates, the market is so competitive, rates will still be seen as being keenly priced. Rate rises should have proportionately relatively little impact on credit card interest as it is generally about 18%pa.
UK investors withdrew £327m from bond funds in June according to the Investment Association as the market priced in UK interest rates rising to 0.75% – which of course came to pass. As the rise was expected, this resulted in more of an orderly exit of investors rather than a stampede so the impact has been gradual.
Bond values are expected to fall as rates rise because higher rates on cash forces those issuing new bonds to offer a higher interest rate to maintain the gap between the return on the low risk cash and higher risk bonds. As a result, new bonds coming to the market have to offer a higher coupon and therefore the prices of existing bonds, which were likely to be issued at a lower rate, would fall in price due to lower demand. That means many of the the assets currently held in bond funds will fall in value if UK interest rates rise. This is good news if investing new money to bonds as coupons should be higher but it its bad news for many existing bond investors.
With investment grade credit spreads (meaning the difference in credit yields versus risk-free government bond rates) near historical lows, the sector offers little value and carries both duration risk (meaning interest rate sensitivity) and credit risk.
More opportunistic sectors of fixed income offering greater insulation from the negative impact of rising interest rates look more compelling. For example high-yield debt is considerably more attractive than investment grade credit.
With regard to currency, if markets think there will be a series of rate increases the pound will strengthen as more international money backs the pound. This in turn will cause the value of overseas investments, held in sterling, to fall. However, if you choose to buy more overseas assets, then your pound buys you more. The FTSE would probably fall as it does better under a weaker pound.
The pound is now at its lowest level against the euro for the whole of 2018 as investors factor in the chances of a Brexit ‘no-deal’.
The obvious impact of this weakening is that inflation is likely to remain stubbornly high, whilst holiday makers will be hit further as holidays abroad become more expensive. Global firms are likely to benefit as foreign profits, if reported in GBP, become more valuable. As the FTSE 100 has a relatively high proportion of overseas earnings, and so investors may see this way upon share values.
What does this do to the case for Direct Lending?
The increase in interest rates – and the likely slow reaction of UK high street banks in increasing savings rates – is likely to be positive news for Direct Lending platforms who are still yielding much greater returns than savings accounts. Of course, with Direct Lending investments, as with any investment, your capital is at risk and so investors should due attention to this before making any investment.
And with the pound suffering, inflation is likely to remain stubbornly high and certainly greater than the rates being offered by banks. The Bank of England’s inflation target is 2% and economists are expecting interest rates to hit that figure in about two years, so savers are likely to have to wait before they see their savings beating inflation.
If you’re thinking of investing in Direct Lending you shouldn’t expect an immediate rate increase either. Although consumer lending platforms that use digital underwriting to price loans in minutes will no doubt pass rates on almost immediately, many platforms have longer underwriting processes. New loans will be extended at the prevailing market rate so the change will be gradual. Loans that are in the process of being underwritten may already have had rates agreed.
The core principle of Direct Lending still remains though. These platforms typically have lower cost bases, so they can pass on returns to investors. This means that regardless of the Base Rate, Direct Lending platforms should always be more competitive for borrowers and investors.