What to do with your money when interest rates rise

Posted at 02/03/14 10:56 AM

MANILA, Philippines - If there is one thing that investors and market analysts around the world watch closely, it is the movement of interest rates.

Last year, following an improvement in the US economy, the US Federal Reserve announced that it would cut its bond buying program. This signaled that interest rates would begin to rise. That announcement set off a series of events including foreign investors pulling out their funds from the Philippines and other emerging markets, the local stock market dropping, and the exchange rate rising to the P45 level against the US dollar. For the Philippines, where interest rates have been at record lows, this created fears that rising interest rates would affect investment and consumer spending.

Most investment houses forecast that in 2014, interest rates would be kept low by authorities in order to aid reconstruction efforts, especially after the damage caused by Typhoon Yolanda, and in order to keep consumer spending going. Just the same, market analysts also say that a spike in interest rates is imminent within the year.

With the prospect of an interest rate hike, one of the questions most frequently asked by people is what to do with their money.

The answer to this is it depends on your current portfolio.

Rising interest rates have their upsides and downsides. On the down side, they could mean higher interest rates on your loans. If you have debt, you may find yourself having to pay more interest rates. On the upside, higher interest rates can mean better yields on some investment instruments you may be holding. What you would do would therefore depend on what your current portfolio looks like, as well as your investment goal.

If you are holding debt with floating interest rates, and you happen to have cash, you may consider paying it off, for instance.

If you are holding equities, you may consider shifting to higher-interest yielding instruments. If you are holding a savings account or cash deposits, then you can just stay put.

An uptick in interest rates is often seen as a signal to move to safer investment havens, such as fixed income instruments.

Fixed income instruments, as the name suggests, provide preset periodic returns. The rates are known by the investor from the beginning and the principal is returned at maturity. Examples of fixed income instruments are government securities, bonds, and certificates of deposit. All are debt instruments, wherein the issuer pays back the investor with the fixed interest rate on a set date. The date that the loan is to be repaid is called the maturity date. Take a 10-year treasury bill with a fixed rate of 3% per annum. An investment of P1,000 would mean a P30 payment until maturity, which is when the P1,000 will be returned to the investor.

When interest rates rise, a simple rule to follow is to head for safety.

The safest haven, of course, is cash, followed by fixed income instruments that have short maturities. This is because the relationship between interest rates and the value of investment instruments is inversely proportional. In other words, when interest rates rise, the value of the instrument falls.

It is important to note that all instruments carry a measure of risk. One measure of risk is the amount of time that you will be holding on to the instrument. The longer an instrument reaches maturity, the higher the risk it carries, for obvious reasons: it is very hard to imagine the risks that may suddenly arise in the future. For instance, there might be a catastrophe that may affect the ability of the issuer to pay off his debt. In contrast, risks in the immediate horizon are easier to predict. Because of this measure of unpredictability, prices of instruments with longer tenors are higher. The 25-year treasury bill, for example, has a higher price than the 10-year T-bill.

As interest rates rise, most prefer to go for instruments with the shortest possible duration. Instruments with durations below one year are generally considered short-term. This allows an investor to simply roll over his or her money at the end of the term, or pull out your money without paying penalties if there is a sudden change in the rates that may warrant a shift to another instrument.

Short-term instruments are traded in the money market. Money markets offer investors two important elements: safety of capital and liquidity. Although they do not offer much in terms of yield, you are assured of getting back your capital within a short period.

Since most fixed term instruments (certificates of deposit, commercial papers, and treasury bills) are purchased and traded by financial institutions in the secondary markets, the best way for retail investors to access these is through unitary investment trust funds (UITFs) or mutual funds. These provide an alternative way to invest in these instruments and may be availed of at an affordable initial investment, usually ranging from P5,000 to P10,000. UITFs are available from financial institutions such as banks and insurance firms. UITFs also allow you to diversify your portfolio and lessen your risks.

Before you make any shift in your holdings, remember that diversification is the key to balancing your risks and wealth objectives. In determining which UITF to avail of, keep your investment goal in mind. Do you want capital safety or growth? Your choice of UITF should be based on your goal, as well as your risk appetite and financial standing. If you are not sure what to do, it is always a good habit to seek the advice of a trusted professional to guide you in managing your investment portfolio.

Grow Your Money is an editorial partnership between ABS-CBNnews.com and Citi Philippines to promote financial education and provide helpful information to Filipinos on how to better manage their personal finances.

Visit www.citibank.com.ph for more information.