The Central Bank of Nigeria 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 in line with those of the central banks of major world economies such as the US and the UK. The Federal Reserve raised US interest rates to 0.75%-1%, the highest in two decades.
In addition, the Bank of England raised its interest rate for the fourth consecutive time since December to 1%. These actions come on the heels of rising global commodity and energy prices.
In Nigeria, the price of diesel shot up to 650 naira per liter and the naira was trading with the dollar at nearly 416 naira, but higher in the parallel market. Commercial banks now charge up to 27% on business loans. All of this prompted analysts to say that the Nigerian economy was heading for a contraction.
The rise and fall of interest rates has its positive and negative implications on the economy of the nation. We’ll discuss how changes in interest rates can affect your investment portfolio.
Effects on government bonds
Typically, when central banks raise their interest rates, it has an effect on bonds, which in many cases is not positive. The effect of an increased interest rate on bonds varies with the term of the bond.
Typically, when central banks raise interest rates, it causes the value of the bond to fall but not its accrued interest. This happens because new bonds can be issued at the new interest rate, which makes old bonds less attractive and causes a sell-off.
For example, you buy 10,000 naira of bonds with a fixed interest coupon of 5%, and the following month the central bank auctions new bonds with an interest coupon of 9% . Your 5% interest rate is fixed, so it will always be valid, but if you decide to sell your bonds, their price will be low. 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 in your portfolio. Indeed, short-term bonds are less sensitive to rising interest rates. Here, you are advised to stay the course. Fluctuating interest rates generally negatively affect long-term bonds.
Effects on term accounts and savings accounts
Most of the time, when the central bank feels there is too much money available, it raises the interest rate to encourage people to save. Ideally, an interest rate hike by the central bank should be good news for savings account holders or time account holders. However, this is not the case for Nigerian savers.
With an inflation rate of 16.82%, not much will come out of savings. While this will increase the amount of interest savers currently get, it won’t do much in the real world, as inflation eats away at a significant chunk of savings.
For fixed deposit holders, there is already a fixed interest rate that does not change. However, for new term deposit accounts, the interest rate will be higher than what was previously available.
Share Price Effects
Rising interest rates are clouding the outlook for many publicly traded companies. Prior to the hike, many businesses were already grappling with increased operating costs coupled with currency scarcity, with the naira trading at 600 naira to the dollar in the parallel market.
This increase will further increase the general operating costs of companies and reduce their production and could even lead to layoffs.
In many circumstances, when the CBN raises interest rates, domestic investors and speculators move their funds from the stock market to other investments like money market debt securities. This negatively affects the earnings and share price among the stock market companies due to a massive sell-off.
Some experts claim that higher interest rates attract foreign investors and while this is true, there is a catch. In Nigeria, other factors such as insecurity, currency risk, etc. discourage foreign direct investment, so that’s a disadvantage.
Higher interest rates do not bode well for the price-to-earnings (PE) ratio and the earnings-per-share (EPS) ratio of publicly traded stocks.
Tajudeen Olayinka, MD of Valmon Securities, argued that a rise in interest rates will cause many investors to buy bonds, which will ultimately drive down bond yields.
It’s fair to say that times could be tough for publicly traded companies, as higher interest rates mean higher interest payments on loans to fund new projects. Already, the interest rate of Nigerian banks stood at more than 20% between 2019 and 2020. All this will probably lead to a reduction in the dividend accruing to investors.
Experts have further argued that the solution lies in building more factories to produce more goods so that supply outweighs demand and prices come down.
Effect on REITs
As the CBN has raised interest rates, it is expected that there will be a rise in the cost of acquiring mortgages and also a reduction in demand for real estate, which will further depress prices. housing.
Low interest rates encourage REITs to access more mortgages and people to buy more homes, leading to higher house prices and more profit for REIT investors.
More profit for REITs means a 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 building materials amid inflation and low public footfall. This does not bode well for REIT investors.
Effect on short sellers
Short selling is an investment strategy that speculates on a decline in the price of a stock or security in the market. In short selling, the trader borrows a security and resells it on the open market, later buys it back at a lower price and returns it.
This is a very risky business and should only be undertaken by experienced traders and professionals. So how does short selling work? Imagine that a short seller borrows 1,000 units of stock in a company at N100 per unit. This totals N100,000. When the price drops to N50 per share, the trader buys and surrenders his 1,000 units while making a profit of N50,000.
Short sellers borrow stocks through a margin account with their stockbroker and pay interest as long as they keep the borrowed stocks. Rising interest rates will mean paying more to borrow, thereby reducing realized capital gains.
Karan Singh of Safe Forex Brokers says short selling can be risky business, but it’s how some asset management firms generate returns for investors when markets go down. A rise in interest rates could make it more expensive to short a stock and a currency, as brokers would charge higher fees for overnight holdings. This will affect returns for investors.
This is especially true now that there are fears of a bear market and even a recession, as many investors will look to sell short. Although some argue that short selling can be harmful, it also creates needed liquidity in the market.
Effect on Mutual Funds
Mutual funds are a kind of investment basket where investors pool their resources to invest in a variety of securities such as stocks, bonds, and other assets. They are generally managed by investment professionals.
Mutual funds in times of rising interest rates may struggle to raise capital, as many investors move their funds to other asset classes. In addition, the return on these investments could decline as the general economy slows due to rising interest rates.
Rising interest rates affect the net asset value of a mutual fund because if investors do not find the mutual fund’s assets attractive or profitable, they will not invest.
Mutual funds are also more expensive to manage than exchange-traded funds (ETFs), so a rise in interest rates only increases their expense ratio, reducing the profits of those in them. have invested.
At the end of the line
As a trader who actively participates in the financial sector, you must be concerned with the activities and policies of the government through its institutions.
The increase in interest rates by the CBN has broad implications for any class of investors in the financial market. As an investor, it is important that you understand these policies and their impacts. This knowledge should serve as a guide as you travel through the market.