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Adjust Your Investments for Rising Interest Rates

By David McEwen

Monday 11th December 2000

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Reserve Bank Governor Don Brash has warned us this week that interest rates may go up over the next two years to counteract inflation.

This may mean 90-day bank bills could rise from around 6.7% to 7.7% next year and 8.7% in 2002. Mortgage rates could go from 8.5% to 9.5% then 10.5%.

Fortunately, Dr Brash has given ample warning, which is better than sudden rate rises. This advance knowledge gives investors the opportunity to restructure their portfolios to benefit from, or at least minimise the harm of, rising interest rates.

Firstly, investors should consider moving their cash assets from long-term vehicles, such as government stock or term deposits, into short-term ones such as cash accounts or bank bills. That's because your money won't start earning a new rate of return until the asset matures. In short-term assets, your money will start earning a higher return within weeks of a rate rise. Long term ones can keep you locked into a lower return for years.

Reducing debt is also a sound step because the costs of paying off a mortgage, credit card or loan tend to move in line with interest rates.

Where the share market is concerned, investors need to avoid shares that are sensitive to changing interest rates.

In general, higher rates make shares a less attractive investment because the differences in returns are not so great. Shares are considered riskier than bank bills or government stock so investors demand a higher return.

This is known as the 'risk premium'. When the premium is low, money tends to flow out of the market and into cash assets.

Here are some types of shares that might be interest rate sensitive:

- Highly geared
When interest rates go up, companies have to pay more on the money they borrow, which can reduce net profit. Companies with a high level of debt relative to total assets (the norm is around 50:50) are likely to suffer more than those with few debts.

- Retailers
Companies that sell consumer items often see sales go down. Not only do customers have less in their pockets because they are paying off loans at higher rates, but the cost of financing new items becomes more of a deterrent. These can also affect the manufacturers of consumer products.

- Banks and finance companies
These have to pay more for deposits but often cannot raise lending rates to the same degree because that puts off potential borrowers. The result is lower margins and lower profits.

- Slow growth companies
Large, solid companies with moderate growth but good yields, such as utilities, typically pay a modest return because they are low-risk. The trouble is, they generally do not have the resources to lift dividends and compete more effectively with high-yielding cash assets.

The good news is that some shares are not affected by rising interest rates.

These tend to be companies that are delivering, or have the potential to deliver, returns well above the cash rate. Investors should look for ones that are highly profitable, have low debt (or are producing a return above borrowing costs) and operate in a fast growing sector.

While investing in such shares is riskier than holding cash, the potential returns often make it worthwhile.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz.

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