By John Loos, Strategist, FNB Homeloans
As interest rates decline, is the fixing of interest rates still a good option?
As interest rates begin to decline, it is natural for some people to lose interest in the option of fixing interest rates, an idea that was very popular with many not so long ago when interest rates were rising. This article is not an attempt to advise the reader on whether to fix rates or not, as there is no right or wrong. Its aim is to suggest some important factors that one must consider when deciding whether or not to fix rates, as well as to point out that the usual times when many people normally rush to fix rates, i.e. when interest rates are beginning to rise, are not always when one gets the “best deals”.
The purpose of fixed interest rates
Late in 2008, interest rates started what became a steady declining trend. South Africa has an inflation target, CPI inflation began to decline, low global commodity prices (most notably food and oil) being the driver, and by as quickly as April prime rate had declined from 15.5% to 12% with more cutting expected at time of writing. Fantastic news, and quite a pleasant surprise to many who had not so long before been witnessing gradually rising rates over a 2 year period. So could one still possibly want to fix one’s interest rate in more positive interest rate times (from a borrowers point of view at least) as those of late?
Firstly, we need to consider what the real purpose of fixed rates is. While economists attempt to predict the future, as do many other market role players, the reality is that the future remains a very uncertain place, and forecasts can often go wrong. For instance, any unexpected breakout of major conflict in the volatile Middle-East, which threatens to disrupt oil supplies, can drive oil prices sharply higher, and this could ruin many any educated inflation and interest rate forecast. Alternatively, the rate at which some developed world governments are printing money in order to stabilise their economies after the recent financial crisis can possibly lead the world to much higher inflation at some future stage, driving interest rates up (that’s not a forecast, just an idea of what’s possible) . This uncertainty is the reality that is always with us, with the only certainty (other than death and taxes) being that interest rates will go up and will go down in future, and fixed interest rates exist precisely because of the fact that future moves in interest rates are uncertain.
Fixed rates should be viewed as a service provided by banks which enables the client to, for a certain period, shift the cash-flow risk involved with fluctuating interest rates onto the bank.
The bank assumes and manages the interest rate risk, and the client obtains certainty over the interest rate payment portion of their cash flows. In return for this benefit, the customer can expect to pay some price.
Should floating rates over the period in question average a rate lower than the level of the fixed interest rate for the period, then the client would have been better off (with hindsight of course) leaving his/her interest rate to float. Conversely, if the SARB were to shock us with interest rate hiking, and the average floating rate over the period is significantly higher than the client’s average fixed rate, then the client will thank his lucky stars should he have fixed his interest rate at the beginning of the period.
While some people may want to use fixed rates to try to “beat the market”, my view is that the decision to fix or float should rest on how much certainty one would like over one’s cash flow. For the person that is more keen to avoid risk, even should floating rates average a lower rate over a specific period than the average fixed rate that he/she fixed at, the value for this person can lie in the fact that he/she has cash flow certainty under a fixed rate arrangement for a defined period, be it 1 or 2 years or even perhaps 6 or 10 years. This can allow such people to sleep more peacefully at night, and thus be worth its weight in gold for that particular period.
Conversely for the more risk-taking individuals, given the feeling of certain forecasters that rates could well remain relatively low and stable for some time, they may feel that they are losing out on an opportunity by fixing rates, especially if you buy into a bearish view that a very weak global economy may send us into a worse-than-expected period of recession, deflation, and very low interest rates.
The main considerations
It is a personal decision therefore, but when considering whether to fix or not, think about the following:
• What is your appetite for risk? Does it cause you major stress? If so, perhaps you lean naturally towards fixing.
• How “close to the edge” are you financially? If your overall financial situation gives you very little leeway to absorb any nasty shocks, you may also lean towards fixing rates.
And the best time?
For those to whom the fixed rate option has some appeal, the next question should be at what stage of the interest rate cycle should one fix rates? Traditionally, we probably find a considerable increase in fixing of interest rates as the SARB starts to hike its repo rate (and prime rate starts to rise). This would appear the logical time to fix one’s interest rates, as history tells us that when the SARB hikes the repo rate for the first time there’s usually more hiking to come.
There’s a catch, though. When a client fixes her interest rates, a bank takes over the risk of interest rate fluctuations from its client. The bank in turn will then hedge out its own risk by trading the client’s prime linked series of future interest payments in return for a series of fixed rate interest payments of equivalent duration in what is called a swap (In practice this gets done in bulk deals by the bank’s treasury division). The price and interest rates at which banks can obtain such fixed interest debt instruments (and thus the fixed rate which they can offer their clients) is determined largely by future interest rate expectations of the market.
Like the individual, the money market also often expects more rate hiking to come when interest rates first start rising (and for a major part of the hiking phase).If the market expects more interest rate hikes during a SARB hiking phase, then the rate which the banks can obtain for their client can appear somewhat unattractive.
The converse also holds true, i.e. that fixed rates on offer start becoming more attractive because market expectation of future interest rates has moved lower. When the SARB started hiking interest rates as at June 2006, should one have tried to fix interest rates shortly thereafter, the fixed rates would have in most cases been higher than the floating rate. To illustrate by an example, as early as mid-January 2009, when prime rate had only fallen by half a percentage point to 15%, FNB was able to offer a 13% fixed rate to a client whose floating rate was prime (15% at the time). This was a big improvement from about 6 months prior, when a fixed rate of 17.15% fixed rate was offered on a prime rate loan which was 15.5% as at end-June 2008, because at that stage the market still allowed for the possibility of further rate hikes.
I certainly don’t want to start predicting anything with regard to future fixed rates. I’m merely suggesting that, while the human instinct is to look for fixed rates during phases when the SARB is hiking interest rates, those may not be the times when one obtains the most attractive fixed interest rates.
Conclusion
So, in short, the decision to fix interest rates or not depends on considerations such as an individuals’ appetite for risk or their own financial position. Fixed rates should be seen as a way of gaining greater certainty over a part of one’s future cash flows, and opposed to being a way to beat the market. If one does generally find the fixed rate option appealing, now is not necessarily a good time to stop looking at fixed rates, because in declining interest rate phases fixed rates can be quite attractive, as opposed to periods of interest rate hiking.