Although global interest rates have been falling for over a decade, the recent economic slowdown arising from the Covid-19 induced lockdowns has further given central banks around the world greater incentives to even keep rates even lower. To achieve their primary goal of price stability and keeping unemployment rate low, interest rate is a very important working tool of central banks. In an economic downturn as seen recently in many countries, the central bank would prefer to keep interest rates low; as it helps to make money available for businesses to borrow at a cheaper rate, increase their productivity and employment of labour. This way they hope to boost economic growth and recovery. At same time, low interest rate is meant to discourage people from holding monies in savings (including fixed deposits, treasury bills and other money market instruments) and encourage investments in real businesses.
Normalcy of Low Interest Rates
The idea of a negative interest had been long considered unthinkable until very recently. Today, the average global bond yield – which is a market determined measure of interest rate is only about 1.00%. As central banks around the world continue pursue expansionary monetary policies, many analysts see a future of low interest rates that has come to stay.
Over the past 5 years, the Central Bank of Nigeria (CBN) has gradually moved its Monetary Policy Rate (MPR) from 14.00% to 11.50%. The MPR is a proxy for interest rate used by the CBN to regulate credit availability and the money supply in the economy. In response, the yield on 10-year bond is currently down to 10.62% while yield on 1-year treasury bills is about 2.06%. Although the rate on Nigerian bonds is significantly higher that the world average, when one considers the impact of inflation, it is clear that the real yield on the Nigeria 10 years bond for instance is around -6.00%. This real return is among the lowest in the world and doesn’t look to change anytime soon.
Rampaging Inflation
Amongst the major economies around the world, Nigeria has one of the highest inflation rate going by the most recent release from the Nigerian Bureau of Statistics (NBS) at 16.47% for January 2021. An unstable, multiple exchange rate regime, lingering farmers-herders clashes and flourishing banditry across most of the agrarian landscape of the nation have connived to keep the inflation rate rising for 17 straight months. Moderate inflation may be good for the economy, but the current trend is anything but good especially for savers, fixed income investors and salary earners. An increasing price level generally erodes the purchasing power of cash and fixed rate investments. Imagine an individual earning a fixed payment of N100,000.00 annually (whether as salaries or investment returns). At the current inflation rate, that sum will be worth only N46,658.38 in 5 years.
Addiction to Treasury Securities.
The year 2017 was a boom for investors in the Nigeria treasury securities (treasury bills and bonds). This was the year that the effective return on 1 year treasury bills almost touched 20.00%, and remained in double digits until the third quarter of 2019. Not many thought that the party would end “too soon”, but in reality the Government was borrowing at such a highly unsustainable rate that it made no sense to do any other business than to lend to it. While investors purses grew fatter, businesses (especially small ones) were starved for funds and suffered.
By late 2019, the CBN had had enough of losing, flipped the script, and started a series of policies that successfully drove market yields to a single digit, touching almost zero percent in January 2021.
Helped by falling global interest rate (with some countries seeing negative rates), the Government has saved trillions of Naira in interest rates over these couple of years. Today, investing in the money market has gone from lucrative to ludicrous. A situation made even worse by a soaring inflation rate.
Financial Repression
In a low interest rate environment, it is expected that borrowing becomes cheap as savings and investments becomes unattractive, thereby increasing money supply in the economy. Increased money supply leads to an increased demand for goods and services, which in turn leads to an increase in the price levels (inflation) if supply remains unchanged. The job of the central bank is to strike a balance between the interest rate and inflation, ensuring that both remain within their target range. In spite of the success of the CBN in keeping interest rate low thus far, the same cannot be said of inflation.
A combination of short-term rates at 2.06% and inflation rate at 16.47% is potentially a gully erosion in an investor’s pocket. This is a combination aptly defined by economists as financial repression. It is a time where holding cash is expensive and few options exist to hedge against the eroding power of inflation rate.
THE WAY OUT
There is no magic bullet solution to the challenges posed by low interest rates and the plundering effects of high inflation rates. To counteract or minimize the impact of the ongoing repression, the following options may be considered.
- Investing in High Yield Stocks
With fading opportunities for earning significant yields from fixed income investments, investing in high yield stocks (companies with a high percentage of annual dividends over share price) can closely mimic the role of fixed income investments in your portfolio. A handful of stocks listed in the Nigeria Stock Exchange (NSE) can still offer between 6.00 – 12.00% in dividend yield alone.
In 2020, the Nigeria stock Exchange was a world beater, returning 50.03%. Although, hardly anyone expects a repeat of the same performance in 2021, with the economy recovering to a growth of 0.11% against expectations there is optimism for some capital appreciation. An addition of stocks with high dividend yields and some potentials for capital appreciation can offer investors the much sought-after protections against inflation.
However, investing in stocks carries a higher level of risk compared to investing in fixed income securities. This risk can be minimized by:
- Overweighting companies with a very good dividend payment history.
- Looking for companies that have a leadership position in the industry where they operate and can raise prices in response to inflation.
- Looking for companies with a quality management team and attractive future prospects.
- Not overpaying for any stock, no matter the attraction.
- Diversification.
- Considering how well a company has responded to new trends and the changing global business landscape.
2. Real Estate
The main source of returns for real estate comes from rental income and capital appreciation. Empirical evidence shows that rental income in Nigeria is less than 5.00% (below the CBN target inflation range of 6.00% – 9.00%), hence the real protection against inflation comes mostly from property appreciation.
Commercial real estates in prime locations that can adjust their rental income along with the business cycle does a better job in earning positive inflation adjusted returns, compared to residential real estates.
Because direct real estate investment demands a high start-up cost and is illiquid, it may not be suitable for small investors and those with high liquidity needs. Such investors may consider investing through a more liquid option such as an exchange traded Real Estate Investment Trusts Schemes (REITS).
3. Foreign Currency Assets
Inflation has a major impact on the direction of a country’s exchange rate. Among other factors, a country with a high inflation rate is likely to see an increase in the exchange rate of its currency relative to the currencies of other countries with a lower inflation rate. This has been the case of the NGN/USD exchange over the last 3 decades.
Over the past 10 years, the official NGN/USD exchange rate has gone from 153 to 380 (a devaluation of about 150%). This implies that if you converted N100,000.00 to USD 10 years ago and kept the dollar equivalent ($654) in your piggy bank at home, your $654 will be worth almost N250,000.00 today. Clearly holding assets in USD would have hedged against inflation over that time frame. I don’t expect you to keep any cash ($) in your piggy bank since there are a selection of suitable dollar denominated assets such as Eurobonds, foreign stocks and foreign Exchange Traded Funds (ETFs) that offers very reasonable returns. A portion of an investor’s portfolio held in dollar denominated assets is expected to enjoy some protections from a decline in the purchasing power of the Naira.
4. High Yield Corporate Bonds
Comforted by the relative safety of government treasury securities, many investors shied away from the corporate bond market because its “riskiness”. Most of these corporate bonds are issued by well-known companies operating in Nigeria with investment grade credit rating, some of which have yields in double digits and as high as 14.00%.
While the probability of default is higher for corporate bonds compared to government bonds, focusing on the investment grade segment of the corporate bond market with proper due diligence should provide some comfort.
5. Take Nothing for Granted – Including the 0.50% offered by your Bank.
Many of us are guilty of despising the paltry interest rate offered by our banks. We often do this at our own peril. When aggregated over a lifetime, these often ignored small interests amounts to a fortune. Unfortunately, many of us never realise this soon, until retirement.
We know that the rates offered by banks on savings account balances and fixed deposits is anything between 0.25% to 1.50%. Clearly, all banks do not offer the same interest rate. Your job is to shop around until you find a bank that offers the best rates.
CLOSING
With the rapidly evolving investment landscape, the cost of “doing nothing” is increasing by the day. It has become very important to monitor, review, and rebalance your investment strategies more regularly with the guidance of a competent investment advisor.
With the Nigerian economy “bouncing back” on it’s path of sluggish economic growth (0.11% at the end of 2020), expect the CBN to set it sights on reining in inflation. However, with the contemporaneous surge in food and energy prices (you already know why), this promises to be a long game.
The publications on this website are purely for providing general information relating to the financial market and for improving financial literacy, it makes no personalised recommendation of individual securities or investment strategies. See here for full disclosure information.
