Part five — Bermuda fundamental financial review. Kinds, uses, and demands of debt.

Interest rates, bond yields, and the quantitative easing era.

The lament goes like this. When, oh when, are we going to see some decent interest rates on deposits, or bonds for that matter?

Yearning for yield, desperately. Capital market volatility continued to wax and wane like the tide rushing in and out of Crow Lane, March 19, 2014, as we listened to the new United States Federal Reserve chairwoman, Ms Janet L Yellen, lay out the quantitative easing fiscal policy path forward. At the end, it was apparent that global investor expectations were resigned to a considerable length of time (say more than six months) before interest rates are raised in the United States.

In ‘A world of cheap money’, according to The Economist* “never in recent economic history have interest rates been so low for so many for so long.” Quantitative easing, first used by the Bank of Japan in the early 2000s, is a non-traditional approach employing the use of ‘cheap money’ to spur increased economic activity.

The Federal Reserve programme purchases large increments of United States Treasury bonds from US financial institutions, thereby flooding the market with excess funds. The strategy is that with the additional cash to draw on, banks will increase lending by making available low-interest rate loans for individuals and businesses.

All money transactions are interrelated. Moneywise today is about to develop the understanding of the world of debt, its uses, risks, and forms — some obvious, others extremely subtle. We will see the interplay between topics two — credit and debit card debt, topic four — investments, and topic five — debt, mortgages and personal loans. For instance, United States Treasuries in the form of bills, notes, and bonds are the debts of the US government. Credit card loans in large groups are bundled together and used as underlying collateral for new securities such as mutual funds. Money market mutual funds, while thought of as cash, or an asset on your personal net worth, are actually a bundle of unsecured extremely short-term loans (debt) between lending institutions, governments, and the like. Mortgages — well we know those are real debt. Who doesn’t think that every month when they send off that large payment for a home?

However, mortgages in the United States (not so much in other countries) are sold off the originating bank’s balance sheet and placed into pools of debt from which new securities can be issued. Mortgage REITS generate income by borrowing at low short-term interest rates and investing in higher-yield mortgage backed securities. Thus, it is possible that an investor in the United States could purchase a mutual fund, a Mortgage REIT (real estate investment trust), for instance, that contains a piece of her/her own mortgage!

It is so hard for the ordinary individual, the man on the street anywhere, not just in Bermuda, to grasp what this policy means and why the interest rates are still so low. Readers, who have not forgotten the ‘good’ times in Bermuda where every long-term deposit earned seven to seven and a half percent, and mortgages were put out at nine percent, still wistfully reflect on those days. Bermuda was then, for intent, a closed monetary society, if you will.

Finances seemed easier to understand, but that high mortgage rate was a large hurdle to saving a down payment toward purchasing a home.

Interest rates are matter of perspective and truly depend upon your own economic circumstances:

If you are a conservative investor, saving for your retirement, you absolutely want high interest rates on your term deposits; conversely, if you and your family just established a new business, you want your credit-line interest rate to be the most competitive (lowest) around.

Low interest rate cycles mean:

— That your home with that big mortgage, means less interest due per month and the excess free dollars can be deployed to pay down that massive principal debt, or as one fellow put it, “the millstone around your neck.” Unfortunately, this is a more correct statement for the United States than here in Bermuda. As noted by the Bermuda Minister of Finance in a recent speech, the “spread** in Bermuda banks between the amount a depositor receives in income, and the amounts of interest a mortgage holder pays is high. Bermuda is not seeing the competitive mortgage rates similar to those offered in the United States.

— You are further challenged if you are retired, living on a fixed income, mostly derived from savings. Your interest income will not keep pace with Bermuda’s incessantly driven upward inflation rate, particularly on everyday necessities.

— Close to your grand effusive retirement, you may consider delaying that celebration because the interest rate on your proposed annuity payout is ludicrously less than inflation. Deferring your pension annuity distribution in a low interest rate market is not necessarily a bad decision, if other options are available. Space does not permit full discourse on this one. Look for another article just on annuity choices.

Your may be putting together some investments in stocks that generate dividends hoping to earn more in appreciation than the current low interest rate environment, but you are unsure where to start.

All investments carry risk. If you find an investment with a great rate, and no one can tell you how this is achieved, you have a problem. The rule is, the higher the rate above the risk free interest rate (risk free rate today is about one percent), the more risk you are taking on.

Argentinian government bonds come to mind. In 1999, the government issued millions of these bonds, with a great 13 percent interest rate. Investors all over the world bought them. Three years later, the Argentinian economy ran into severe trouble. Every investor received a letter from the government stating that they would buy back the bonds, but at a severe discount — 30 cents on the dollar. If you had invested $10,000, you would receive $3,000 back. Some return! 13 percent interest rate, but a 70 percent principal loss.

Readers, we’ve got a number of features running almost simultaneously: doing business with real property in the US, the Bermuda Financial Fundamental Series, and the property and casualty insurance series (that generated some very very good questions). I will do my best to keep you up to speed.

Sources:

A world of Cheap Money, The Economist, April 6, 2013.

Wikipedia: quantitative easing

** The spread is a reference to the difference in interest rates between the amount of interest charged on a mortgage, compared to the interest rate paid on a term deposit in Bermuda banks.

For the first in this series, please refer too January 18, 2014 — ‘Crack on with the financial review.’

The Pondstraddler* Life™ Consultancy to individuals and businesses on planning for international tax, immigration, investment, retirement, legacy, and related financial challenges to the lifestyles of internationally mobile citizens residing, working, crossing borders, and straddling ponds in the North Atlantic Quadrangle: United States, Canada, United Kingdom, Europe, and the island of Bermuda, the premier international finance centre.

Contact: martha@pondstraddler.com

* Pondstraddler. A person with one foot on each shore whose heart resides in both countries*