Want to invest? Here’s how interest rates could affect your returns

From property and savings to bonds and shares, investment expert Roger Montgomery explains how rate changes can affect your assets.

I suspect you know something about interest rates. You hear folks complaining about how low they are and how they're not earning anything on their savings. On the flipside, you'll hear friends celebrating low rates and how they've helped them afford their first home.

But how many stories explain the relationship between interest rates and the value of investment assets?

How interest rates work in Australia

First, a bit of background. When you deposit your money in the bank, you are actually lending the bank your money. That's why, normally, they pay you some interest for borrowing your money from you. They'll then lend that money to someone who wants to buy a house, for example.

The difference in the rate they pay on your deposit and what they charge someone who has borrowed to buy something is their interest rate margin. It's their gross profit, if you like.

When a bank or the government or a company borrows large amounts of money, they will issue a security called a bond. The buyer of the bond is the lender and the issuer of the bond is the borrower.

Additionally, there are short-term interest rates and there are long-term interest rates. This is where borrowers want to borrow for different lengths of time. Consequently, they issue securities of different terms and different interest rates apply.

In Australia, the shortest-term rate is the interbank overnight cash rate provided by the Reserve Bank of Australia (RBA). The interbank overnight cash rate is the rate offered by the RBA to commercial banks (think NAB, CBA, etc) on the money they deposit with the RBA.

From overnight cash, all the way out to 31 years, each security has a different rate. Typically, there is more risk and uncertainty over longer periods of time, so higher rates normally apply to longer term loans.

Why the official cash rate matters

The overnight cash rate target is the rate you hear discussed in news stories about whether the RBA has left rates unchanged, lifted them or lowered them.

And while the overnight cash rate is big news, it is not the only rate that influences what banks charge on mortgages. That role is played by the 3-year Australian Government Bond or security, which the RBA has recently reduced. Now, both the 3-year Australian Government Bond target rate and the cash rate are 0.10%.

Thanks to the RBA's somewhat unconventional actions, banks now have a very low rate to fund mortgages and business loans, which is why you and your friends have been able to borrow at an historically low interest rate.

But of course, if your friends can borrow cheaply, so can everyone else. So, what happens? More people borrow to buy a house, they all turn up to the same auction and compete for the same house and it goes up in price. It goes to the person who is willing to borrow the most and pay the most. This is what causes property prices to go up when interest rates fall.

How interest rates affect the value of investment assets

It's not only property that goes up when interest rates go down.

Every investment asset is negatively correlated to interest rates (think property, shares, bonds, savings, superannuation, etc). Interest rates act like gravity on the value of an investment asset. When rates are high, the gravitational force is strong and investment asset prices fall. When rates are low, the gravitational force is weak and investment asset prices float up.

This is due to something called "present value". Let me explain, because once you know this, it will be very helpful for predicting what investment asset prices could do next. It will help you to time your purchases over the next few decades.

Suppose I offered you the choice of $10 today or $10 in 10 years' time. Which would you choose?

Most of the time, you would choose today, because there are so many risks and unknowns between now and the end of a decade.

You also know intuitively that $10 in 10 years' time is not worth as much as $10 today. Inflation will make sure that it won't be able to buy as much in a decade as it can buy today. In other words, $10 in 10 years' time is worth something less than that today. Keep that in mind for a second.

Now, we also know that if we invested some money today, and it grew, we could get to $10 in 10 years. How much we need to invest today to get $10 in a decade's time depends on the interest rate we earn.

If the interest rate is low, we would need to invest a high amount today. If the interest rate is high, we would need to invest a lower amount.

Hopefully you see something happening here: The value today of $10 in the future changes depending on the interest rate.

Example: How interest rates help you work out the present and future value of assets

If we knew we were receiving $10 in 10 years and wanted to work out what that was worth today (the "present value" or PV), we would have to think about the interest rate.

If we apply an interest rate of 0.5% for the next 10 years, the PV of that future $10 is $9.51. In other words, if we invested $9.51 today at 0.5 per cent per year, we'd have $10 in 10 years time.

If, however, we apply an interest rate of 11% over the next 10 years, the present value of a future $10 is approximately $3.85. We'd only need to invest $3.85 today at 11% per year and we'd have $10 in 10 years.

As you can see, interest – the gravitational force at work on assets – has a huge impact on today's value of a future dollar. In the above example, when interest rates jumped from 0.5% to 11%, the PV fell from $9.51 to $3.85.

Why all investors need to pay attention to interest

Now, investment assets produce cash flows. Residential, commercial and industrial property produces rent, agricultural land produces income from crops and meat (production), and businesses produce profits.

All of these are investment assets and they are all worth the present value of their future stream of income. The job of an investor is to forecast or estimate those cash flows. Importantly for this discussion, however, is that the value of those investment assets will rise and fall depending on what interest rates do.

For the last 30-odd years, interest rates have been steadily declining. Now ask yourself what have assets prices done? Of course, the theory says they should have risen. And what did they do? They have surged, setting record after record.

More than three decades of declining interest rates has resulted in rising stock markets, rising property prices and rising business valuations. Baby boomers, the generation that were 30 years old back in the 80s, have ridden a wave of declining interest rates and made a fortune on property, shares and the sale of their businesses.

But don't mistake genius for a rising market. One day interest rates will go back up. And when that happens in earnest, asset prices will decline. Now you know why.

Roger Montgomery is the founder, chairman and chief investment officer of Montgomery Investment Management. He is a renowned value investor with 30 years' experience. Following a successful career as an analyst and public company chairman, Roger published the first edition of his stock market guide, Value.able, in 2010, becoming an Australian bestseller in just 16 weeks. He is an awarded presenter on the subject of investing and appears regularly on the ABC. Roger also writes regular commentary for major financial publications and newspapers. You can find more insights from Roger at rogermontgomery.com.

Disclaimer: The views and opinions expressed in this article (which may be subject to change without notice) are solely those of the author and do not necessarily reflect those of Finder and its employees. The information contained in this article is not intended to be and does not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort. Neither the author nor Finder has taken into account your personal circumstances. You should seek professional advice before making any further decisions based on this information.

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Pictures: Getty Images, Supplied (Roger Montgomery)