The Central Bank of Nigeria has raised interest rates from 11.5% to 13.5%. This was in response to rising inflation in Nigeria which stands at 16.82%.
The CBN's action is consistent with those of the central banks of leading economies globally such as the US and the UK. The Federal Reserve increased interest rates in the US to 0.75% - 1%, the highest in the past two decades.
Also, the Bank of England raised its interest rate for the fourth consecutive time since December to 1%. These actions are coming on the heels of rising prices of goods and energy globally.
In Nigeria, price of diesel soared to as much as N650 per liter and the Naira was trading with the dollar at almost N416, but higher on the parallel market. Commercial banks now charge up to 27% on loans to businesses. All these have prompted analysts to say the Nigerian economy is heading for a contraction.
The rising and falling of interest rates has its positive and negative implications on the economy of the nation. We will discuss how changes in Interest rates can affect your investment portfolio.
Effects on Government Bonds
Generally, when central banks increase their interest rate, it has an effect on bonds which in many cases is not positive. The effect of increased interest rate on bonds varies according to the length of the bond.
Generally, when central banks increase interest rate, it leads to a drop in the value of the bond but not its accruable interest. This happens because news bonds may be issued in line with the new interest rate which makes old bonds less attractive and prompting a selloff.
For example, you buy N10,000 worth of bonds that have a 5% fixed coupon interest, and the next month, the central bank auctions new bonds that come with a 9% interest coupon. Your 5% interest rate is fixed so it will still hold but should you decide to sell off your bonds, they will be lowly priced. This is because they will be better options available in the bond market offering the latest interest rate of 9%.
However, a higher interest rate might not affect you if you have a short term bond on your portfolio. This is because short term bonds are less sensitive to interest rate increase. Here you are advised to stay on course. Interest rate fluctuation usually affects long term bonds adversely.
Effects on Fixed Deposit and Savings Accounts
Most of the times, when the central bank feels there is too much money in supply, it increases the interest rate to encourage people to save. Ideally, an increase in interest rate by the central bank should sound as good news to saving account holders or fixed deposit account holders. However, that is not the case for Nigerian savers.
With an inflation rate of 16.82%, nothing much will come out from savings. Although it will raise the amount in interest bank savers currently get, it won't do much in the real world as inflation eats up a sizeable chunk of savings.
For fixed deposit holders, there is already a fixed rate of interest which does not change. However, for new fixed deposit accounts, the interest rate will be higher than what is previously available.
Effects on Price of Stocks
The increase in interest rate poses a gloomy outlook for many companies listed on the stock exchange. Prior to the hike, many companies already struggled with an increase in running cost coupled with scarcity of foreign exchange with the naira trading at N600 to the dollar in the parallel market.
This hike will further increase overhead running costs for companies further and reduce their output and could even cause layoffs.
In many circumstances, when the CBN increases interest rate, domestic investors and speculators move their funds from the stock market to other investments like debt instruments in the money market. This negatively affects the revenue and price of stocks among companies in the stock market due to a massive selloff.
Some experts argue that higher interest rates attract foreign investors and while this is true, there is a catch to it. In Nigeria other factors such as insecurity, exchange rate risk etc. discourage foreign direct investment so, this is a drawback.
Higher interest rates do not bode well for the Price/Earnings (PE) ratio and the Earning Per Share (EPS) ratio of stocks listed in the stock market.
Tajudeen Olayinka, MD of Valmon Securities argued that a hike in interest rates will drive lots investors to buying bonds which will eventually drive down the bond yields.
It is fair to say these could be tough times for companies listed in the stock market as increased interest rates mean higher interest payment on loans to finance new projects. Already interest rate from Nigerian banks stood at over 20% between 2019 and 2020. All this will likely cause a reduction in the dividend accruing to investors.
Experts further argued that the solution lies in building more factories to produce more goods so that the supply outweighs the demand and prices fall.
Effect on REITs
As the CBN have hiked interest rates, it is expected there will be a hike in the cost of acquiring mortgage loans and also a reduction in the demand for real estate which further lowers house prices.
A low interest rate encourages REITS to access more mortgage loans, and people to buy more homes which leads to an increase in property prices and more profit for REIT investors.
More profit for REITs mean higher dividend for its shareholders. This may not be the case for Nigerian REITs as they have to pay higher interest on loans, higher prices on construction materials amid an inflation and low patronage from the public. This does not augur well for investors in REITs.
Effect on Short Sellers
Short selling is an investment strategy that speculates on the decrease in price of a stock or security in the market. In short selling, the trader borrows a security and sells it on the open market, he later rebuys it at a lower price and returns it.
This is a very risky venture and should only be undertaken by experienced traders and professionals. So how does short selling work? Imagine a short seller borrows 1,000units of stocks in a company at N100 per unit. This totals N100, 000. When the price decreases to N50 per share, the trader buys and returns his 1,000 units while making a profit of N50, 000.
Short sellers borrow stocks through a margin account with their stockbroker and are charged interest for as long as they keep the borrowed stock. The hike in interest rates will mean paying more for borrowing thus reducing any capital gains realized.
Karan Singh, from Safe Forex Brokers says that shorting may be a risky venture but is the way some Asset Management Companies generate returns for investors during falling markets. A hike in interest rates could make it more expensive to short a stock and currency, as the brokers would charge higher fees for overnight holdings. This will affect returns for investors.
This is especially true now that there is a fear of a bear market and even recession as many investors will be looking to short sell. Even though some argue that short selling can be harmful, it also creates the needed liquidity in the market.
Effect on Mutual Funds
Mutual funds are a kind of investment basket where investors put their resources together to invest in a variety of securities such as stock, bonds and other asset. They are usually managed by investment professionals.
Mutual funds in times of increased interest rate may find it difficult to raise capital as many investors move their funds to other asset classes. Also, the return from these investment might reduce as the general economy slows down as a result of the hike in interest rate.
Rising interest rate affects the net asset value of a mutual fund because if investors do not find the assets under the mutual fund attractive or profitable, they will not invest.
Mutual funds are also more expensive to manage than Exchange Traded funds (ETFs) so a hike in interest rates only makes their expense ratio higher thus reducing profits for those who have invested in them.
As a trader who's actively participating in the financial sector you should be concerned about the activities and policies of government through its institutions.
The CBN's raising of interest rates has broad implication for any category of investor in the financial market. As an investor, it is important you understand these policies and their impacts. That knowledge should serve as a guide when making your moves in the market.