How to Invest in a Low Interest Rate Environment

The coronavirus pandemic has pushed interest rates to new record lows in many countries, including the U.S. Rates that now are hovering near zero make it even more difficult to build wealth, and the current environment is pushing investors to grapple with some tough questions. Should you stand firm on current investment strategies? Do you take on more risk in order to capture more income and higher yields? And where is the best place to look for good investment alternatives in the current market?

Investors have become accustomed to a low rate environment. Central banks around the world cut rates sharply following the Great Financial Crisis more than a decade ago as a means to stimulate borrowing and economic growth. Those same banks dropped rates even lower this year following the economic crisis caused by the global health crisis. In the U.S., the federal funds borrowing rate – a key benchmark for bank lending rates and yields on fixed-income assets – is at 0.25%. The Federal Reserve Board also has indicated that rates will likely remain near zero through 2021, and potentially as far out as even 2023.

What that means for investors who hold cash in bank accounts is that they are earning virtually nil in bank-paid interest. In fact, for those who have to pay bank fees to maintain checking or savings accounts, it is likely that account holders are even losing money. The low interest rates also weigh on yields for low-risk, fixed-rate investments such as certificate of deposits, bonds and treasuries or T-bills. For example, Apple issued $8.5 billion in bonds in May with different maturities to help finance a share buyback plan. Investors who bought Apple’s five-year bonds receive a 1.125% coupon rate, while those with the shorter three-year bonds were willing to accept an even lower return of 0.75%. Although that cheap financing is a great deal for Apple, it is not generating much excitement among investors.

How do low rates impact investment markets?

Despite the continued uncertainty related to the pandemic, history has provided a few hints to what investors can expect when navigating in a low interest rate environment. Some examples include:

• Stock markets rise.The U.S. Dow Jones Index started 2020 at near record highs of 28,868. Despite significant volatility, the Dow had regained much of its losses. Immediately follow the presidential election in early November, the Dow had bounced back to 28,400+.
• S. dollar may decline in value. Most banks expect the U.S. dollar to end the year weak relative to other currencies. Over the past 90 days, the exchange rate on the U.S. dollar to the Chinese Yuan has declined from 6.95 to 6.61.
• Bank stocks fall.Low rates can make it challenging for banks to maintain profit margins, and that has clearly been the case in the U.S. Stock prices of major banks such as Wells Fargo have dropped precipitously in 2020.
• Interest in real asset investments may rise. Real assets, such as property and commodities, often become more attractive for investors during periods of low interest rates.

Balancing risk & returns

The low interest rates now common around the world have left many investors with inadequate returns on their bonds and virtually no return on cash investments. At the same time, many investors are wary of the wild volatility in stock markets that has existed over the past year. What are the options for preserving capital and building wealth in the current environment?

Stocks: Is it time to be bullish or bearish on stocks? The low interest rates tend to make stocks look more attractive, especially those companies that also deliver dividend yields. The downside risk is the continued market volatility. Key stock market indexes, such as the Dow Jones, Nasdaq and S&P 500, have all been prone to big daily moves due to continued uncertainty related to the pandemic, negative economic news and geopolitical issues.

Bonds: Investors have traditionally looked to bonds to provide income, capital preservation and a hedge against inflation. However, the current low payout on bonds is not a strong incentive for investors and becomes even less attractive in the likelihood of even modest inflation levels. Investors can choose to buy higher risk bonds, such as junk bonds, that offer higher yields. They also can invest in blended bond funds that include a mix of bonds to offset risk and boost overall yields.

Real estate: A low-interest rate environment often fuels interest in alternative investments such as commodities, collectibles and real estate. Investors like these assets because performance usually does not correlate to that of the stock market. For example, owning real estate is attractive in a low interest rate environment, because it can provide income from rent payments, and the potential for future appreciation for properties that increase in value over time. Importantly, real estate values are less volatile, and that stability is why real estate is often used to diversify investment portfolios. Real estate ownership also offers tax advantages such as depreciation.

How low could rates go?

The near zero interest rates in a still uncertain economic environment has raised the question of whether rates may drop into negative territory. In Europe, interest rates are at zero with countries such as Switzerland and Japan reporting negative interest rates. That is concerning for investors as it means that they end up having to pay banks to hold their money. No one has a crystal ball to predict how interest rates may move in the future. Although it is not impossible that rates will go lower, most U.S. economists do not expect negative rates to materialize in the U.S.

The continued low interest rate environment also highlights some common investment themes that have been proven to help build wealth over time. One is to understand your individual tolerance for risk, and not let the low rate environment push you out of that comfort zone. Two, is the importance of building a diversified investment portfolio to both manage risks and achieve higher overall blended returns. Three, it is important for investors to conduct careful due diligence and work with a trusted advisor.