How Lower Rates Lower The Boom
What's not to love about lower interest rates? Borrowing costs go down, mortgages are cheaper, companies pay off their debts sooner, the economy grows faster, and everybody's happy, right? Not quite. For all the hosannas heaped on lower rates, people and companies are being hurt. And as rates continue to slide, the pain is sure to grow more severe.
Of course, those who suffer most are the millions of retirees who rely on short-term fixed-income investments, such as certificates of deposit. But they're not the only ones whose fortunes depend on a steady stream of income. Indeed, lower rates are depressing the income stream of a diverse group of investors, companies, and industries.
REFINANCE FEVER. The decline in rates is already beginning to wreak havoc on a good chunk of the $2.3 trillion in public mortgage-backed debt. Mortgage-backed securities are supported by pools of mortgages, either residential or commercial. Aren't lower rates good for mortgages? Sure, for people who want to originate or refinance one. But when rates fall, investors in securities that have existing mortgages as collateral suddenly find mortgage holders prepaying their debt by refinancing. That means the value of the mortgage-backed security falls because investors no longer earn the higher interest rate.
Until recently, it was just mortgage-backed securities sporting interest rates of 7.5% or above that were experiencing higher-than-expected prepayments. But now, the market is waiting for the next shoe to drop, says Ken Boertzel, who manages about $5 billion in mortgage securities at New York Life's asset-management business. The market is primed, he says, for an explosion of prepayments on 7% securities if the 10-year Treasury note trades around 5.25%--close to where it is now. So far, that hasn't happened, and mortgage rates have remained fairly stable. But people seem more willing to refinance today, and the costs of refinancing are much cheaper. "There is concern that some very recently issued mortgages will start to prepay," says Michael Cloherty, a bond strategist at Credit Suisse First Boston Corp.
While long-term Treasury bond funds have sparkled in recent months, returns on mutual funds specializing in mortgage-backed securities, such as those issued by the Government National Mortgage Assn. (GNMAs), are dwindling. Through July, the 136 GNMA funds tracked by Morningstar Inc. were underperforming the Lehman Brothers Fixed Income Aggregate Index by about 2%, with the average fund returning 3.4% and the worst-perfoming fund up less than 2%. The results for August are sure to show even further deterioration.
Things are a lot worse for institutional holders of "interest-only" strips. IOs are securities that isolate the interest payments on mortgages from the principal payments that also flow into the securities and pay only the interest to investors. "Under falling rates, IOs would take most of the beating, and that has been the case in the past few days," says Tae H. Park, a vice-president at Chase Securities Inc.'s mortgage-backed-securities research department. Park points to IOs issued by government-sponsored entities such as Federal National Mortgage Assn., or Fannie Mae. Such agency IOs backed by 7% coupons lost 5% of their value in the past week, says Park. Those same IOs have lost 30% of their value from the beginning of the year.
Individuals aren't the only ones who refinance. Much of the record amount of corporate-debt issuance in 1998's first half was corporate refinancings. "It's a big boon for corporations, but for people who owned those bonds, they got an attractive investment called away," says Cloherty. Sure, a decline in rates raises the value of a bond. And bondholders are sitting pretty in terms of capital appreciation. That does little good, however, if the bond has a call provision.
While falling interest rates give businesses a boost by letting them lessen interest payments, certain industries will take a hit. Insurers with large portfolios of traditional life insurance, such as Torchmark, American General, and Liberty, may be feeling the heat. Low rates make it tough to sell products that make long-term fixed-return promises, such as classic life and fixed-annuity products, notes Joan Zief, an insurance analyst at Goldman, Sachs & Co. Fixed-annuity sales have already been declining as rates have come down, she says. Also, if a traditional life-and-health insurer derives its earnings just from excess cash flow, then when interest rates drop, the yield on its portfolio drops as the company invests new money, and money from maturing bonds, at lower rates. With a flat yield curve--meaning that long rates aren't much higher than short rates--it becomes difficult to earn a decent return on new business.
Home-equity lenders such as Advanta, Aames Financial, and United Cos. Financial are also seeing a dark side to lower interest rates. Some of these specialty-finance companies, already suffering from greatly increased competition, take another blow if prepayment levels on mortgage securities they have packaged and booked on their balance sheet speed up even further. Many smaller specialty-finance companies use "gain on sale" accounting. That lets them record profits they expect to receive over the life of a loan at the time that they originate it. If a company counted on having the loan for seven years, and the loan gets paid off in three, the company has to lower its equity and take a write-off, notes Mark C. Alpert, an analyst at Bankers Trust New York Corp.
Another impact on Corporate America may come via defined-benefit pensions. If rates stay at low levels or fall further, actuaries may have to start lowering the rates of return they assume when calculating how much more money companies need to pony up to adequately fund their plans. Granted, those are long-term projections, so adjustments aren't taking place yet. But "with today's rates so low, my expectation is that there will be some lowering of long-term blended return expectations, because that certainly seems to be the trend today," says Arthur Andersen partner Alan A. Nadel.
DANGER ZONE. Where an impact from lower rates may show up sooner is in the pension liabilities that defined-benefit plans report at the end of the year. As rates drop, the Securities & Exchange Commission requires that corporations measure their liabilities against the lower market rates. For underfunded plans, that may trigger onerous requirements and mean pumping more money into plans. "We are telling our consultants to warn clients about this when they are preparing their cash budgets for 1999," says Ethan E. Kra, chief actuary for consulting firm William M. Mercer Inc. So far, a rising stock market has offset any impact from lower rates, since most pension funds are 60% invested in equities today. "The possible danger is: What if we get a recession and a real stock market correction at the same time that rates are low?" says Alan Parikh, a principal at Chicago Consulting Actuaries.
But of more immediate concern to a broad swath of investors is the impact of lower rates on the cash flow from short-term investments. Take a retiree following a system of withdrawing 5% a year who has been earning a 6% to 7% yield on his two- and three-year CDs. With inflation at 2%, they're just about holding their portfolio value steady. "But with interest rates in the 5% range, and with CDs maybe falling to 4%, these people are going to be eating into principal," says Lou Stanasolovich, president of Legend Financial Advisors Inc. in Pittsburgh.
It's not just retirees who need to take a harder look at spending and savings levels if lower rates become a long-term reality. "I'm a baby boomer, and I expect relatively low real rates of return on savings for the rest of my life," says Robin Grieves, director of fixed-income research at HSBC Securities Inc. Undersaved boomers who had planned on retiring in 10 to 15 years may have to make a significant change in lifestyle in order to meet that goal now, he says.
Most Americans are rooting for a further decline in interest rates. But while they cheer, a lot of other people will be paying a price.