A Banker’s Note: The Influence of Interest Rates on Investment Decisions

15 September 2020, by Piet Nieman

Generally, investment opportunities include the following generic options:

• Investment in Governmental activities in a sound constitutional environment, which acknowledges the responsibility of providing real returns and creating infrastructure that will support and enable long term economic growth.
• Cash deposits and related products at reputable banking institutions, normally backed by sound banking systems in acceptable international jurisdictions.
• Fixed assets, normally property related, within jurisdictions that legally respects private ownership and allow economic activity at such properties.
• Stock Exchange exposure within jurisdictions that enable free raising and utilization of capital, backed by legal frameworks that support and protect the investment community.
• Private Equity, where entrepreneurial skills and surplus capital engage.

Each of the categories above have multiple products and derivatives which influence their financial profile. However, the performance of the category will always be determined by the investment management chain. What we did not include in the above categories is Commodity Investment, which is not always easily accessible and which can be complicated.

Investment decisions are normally based on Risk/Return profiles, which is included in the different investor mandates (individual or family wealth, community wealth, pension funds or other insurance related funds). Risk/Return profiles may include the following:

• Government Bonds: The risk profiles of such bonds are determined by International Credit Agencies. If funds are invested according to the guidance of established International Credit Agencies, such investments are supposed to be low risk investments and will be priced accordingly.
• Risk: Dependent on Credit Ratings, but normally seen as low risk, if included in the investment profile.
• Return: Dependent on Credit Ratings, but if accepted as an option, normally low return.

• Cash Deposits: Historically Cash Deposits at reputable institutions were viewed as safe havens and therefore provided low returns. Credit ratings also influence this instrument.
• Risk: Low risk at reputable institutions.
• Return: Low

• Fixed Assets: Historically viewed as low risk if well located. Often preferred due to its return profile. It can provide constant cash returns, but it is heavily dependent on the success of the occupant of the property. The return profile will be determined by the property location (mainly the ability to replace the current occupant with a similar or better occupant) and the success of the current occupant, which will enable the occupant to pay the property owner the agreed rent.
• Risk: Low risk if tenant can be replaced by a similar or better one. Backed by an asset that does not disappear. Negatively influenced by lack of liquidity.
• Return: Linked to risk, but could provide fixed sustainable earnings which drive the return rate downwards.

• Stock Exchange: The heart of capitalism and the free market. Risk profiles differ from company to company and from industry to industry. It can change overnight or over a decade. The management of such investments are left in the hands of asset managers, which are supposed to study companies and have enough info to decide on allocations.
• Risk: Depends on which company / industry, but generally seen as higher risk than the above.
• Return: Normally higher than the above.

• Private Equity: Seen as high risk as the exposure could be linked to one operation and dependent on limited management skills of one operation. However, this category has been key to economic growth and the creation of personal and family wealth.
• Risk: Viewed as highest risk, mainly because of a lack of regulatory framework.
• Return: High return, because the investor is close to the source of the returns, there are no or few intermediary role players.

Interest Rates determined by Central Banks can have a huge influence on Investment Mandate Holders’ decisions. Mandate holders normally would like to have a balanced portfolio, which could include the following:

• Low Risk Short Term Return to address any potential crisis: 15% to 20% Cash Deposits
• Low Risk Medium to Long Term Return to bank portfolio growth and cover minimum requirements: 15% to 20% Government Bonds
• Long Term growth with moderate returns, but with as little as possible risk: 20% to 25% Fixed / Property Assets
• Medium Term Growth at acceptable risk: 30% to 40% Stock Exchange
• High Risk Medium Term Growth only if a real opportunity arises: 5% to 10% Private Equity

If Mandate Holders are uncertain about the investment framework they are operating in, they tend to fall back to Cash Deposits. Therefor they are taking investment funds out of the market and trust banks to provide secured lending to established businesses, with a low risk profile. This limits growth funding and could lead to stagnant market conditions.

However, there is a limit to the shortterm requirements of Mandate Holders and if the Cash Deposit returns drop to extremely low levels, this investment class will no longer be an option. In developed countries it has become the rule and banks no longer are able to provide returns on cash deposits. In developing countries banks are still able to provide returns on cash deposits, mainly because of the fact that banks are still fulfilling an important role as provider of funding for business activities.

If the Central Banks of developing countries drives the interest rates downwards, it forces Mandate Holders to exit Cash Deposits and replace it with buying Government Bonds, which should be of the same risk profile and which should benefit economic growth. But Mandate Holders entered into Cash Deposits, because of uncertainty about investment environments and frameworks, where, ironically, governments are the main decision makers.