The Low Interest Rate Trap

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For investors who depend on interest rates for income or investment, the future looks bleak. Interest rates are at the lowest level we have seen for decades and are likely to stay low for some time. Prior to the Global Financial Crisis of 2008, many fixed interest investors chased after the double-digit returns offered by finance companies, only to discover that high returns reflect high risk. The huge losses following the finance company collapses resulted, amongst other things, in mandatory credit ratings for financial institutions. However, it’s one thing for an institution to publish its credit rating and its another thing for that rating to be seen and understood by investors.

At present, it is possible to get an extra 0.15% or so from an institution that has a BBB rating, over and above what is on offer from an institution that has an AA- rating. This is a very small reward for a disproportionate increase in risk. An AA- rating is very strong with a 1 in 300 probability of default over 5 years while a BBB rating is considered ‘adequate’ with a 1 in 30 probability of default over a period of 5 years. That’s a ten-fold increase in risk for an extra 0.15% interest. As we head into a period of low economic growth and increased unemployment, there is potential for increased defaults on mortgages and loans. It was this that contributed to the housing market crash in the USA which in turn triggered the Global Financial Crisis. That is not to say that we are heading for another crisis, but the next few years will be a period when investment risk needs close scrutiny. It will be tempting for investors to fall into the low interest trap – chasing higher interest rates without regard for risk.

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