In a World of Low and Negative Interest Rates, What Is an Investor to Do?
It’s all over the news: The Federal Reserve has lowered interest rates yet again. Why does this happen? And what would this mean for investors?
Low interest means what you think – it may be less expensive to finance large purchases like a car or home, but it can also mean lower returns on certain types of investments like bonds, CDs and more. But how can an investor earn higher income when this occurs? Alternatives might be one of the best… well, alternatives.
Let’s step back a moment and talk about the role of central banks with regard to the interest at your local bank. Most countries have a central bank. In the US, it’s called the Federal Reserve Bank or the Fed. These central banks loan money to local banks at a federal funds rate; the local banks then turn around and loan it to consumers at a higher rate – thereby making money on the difference, or spread. So, for instance, if the federal funds rate is 1.75% and your bank lends you money at 3.75% on a 30-year loan, the local bank is making money on the 2% difference over 30 years’ time.
For the first time since 2008, we have seen not one, not two, but three interest rate cuts from the Fed this year. Central banks lower their interest rates to stimulate the economy by incentivizing investors to seek out investments that they hope will grow at a higher rate than cash. As a result, the market usually rallies after a rate cut. In a sense, the Fed is saying, “Don’t just let your money sit there, do something with it!"
How low can interest rates go? Lower than you might think. There are central banks in Europe and Asia that have lowered their interest rates below zero. Simply put, holding cash in an account with a negative interest rate means you will take out less than you put in; for the risk-averse, it’s a safe way to hold cash without losing too much value. But it doesn’t bring you income.
So what can investors do to earn higher income? Since the Jumpstart Our Business Startups (JOBS) Act of 2012 was signed into law by President Obama, the world of alternative investments, specifically investing in private funds, has been more accessible for the average investor.
Alternative investments include real estate, hedge funds, private equity, commodities, marketplace lending and precious metals. Once perceived to be only available to institutional and ultra-high-net-worth investors, an increase in technology-enabled platforms and investor awareness has allowed for these asset classes to grow and become more mainstream.
One of the differentiating features of alternative investments is that they are not “marked to market,” meaning that they don’t go up and down in value based on the stock market. They are not valued daily like investments in the public markets of the NASDAQ or the NYSE. It doesn’t mean they won’t change in value, but they aren’t likely to be as volatile as stocks can be based on the latest news report.
Let’s talk a little bit about one such alternative investment class – private debt – and how these investments might perform favorably from simply letting your money sit.
Since interest rates are low, banks are less interested in issuing short-term loans. After all, they make their money on the spread – or the difference in interest rates over time. Short-term loans don’t offer enough time for them to earn significant interest. So what can small businesses and individual investors do when they need capital right away? They can go to their peers in the marketplace. It’s called marketplace lending.
Let’s take an example of marketplace lending in private debt. It’s often called Fix & Flip.
There are a ton of shows on TV right now featuring Fix & Flip entrepreneurs – people who buy foreclosed or dilapidated houses, remodel them and then sell them for a substantial profit. In order to get in on the best deals quickly, flippers need hard cash. Investors cover a significant percentage of the original price of the house plus remodeling costs. These investors lend the money for a short term, but earn interest at a rate higher than the market. If all goes well, it’s a win-win situation: The flipper gets the cash he or she needs much more quickly than they would from a banking institution so they can fix up the property and make a profit, and the investor gets a great interest rate on their cash in a short period of time.
Smart business people have created companies and digital platforms that specialize in these kinds of quick-turn, peer-to-peer loans. Without getting involved in the nuts and bolts of the transactions, accredited investors can invest through these companies to take advantage of these types of short-term capital investment opportunities. Marketplace lending can involve commercial real estate, small company capital investments and other opportunities that banks don’t want to serve.
Interested in learning more about alternatives? We created the Millennium Alternative Investment Network® to help advisors and investors:
- DISCOVER the basics of alternative investing and how they can be part of your retirement portfolio.
- RESEARCH the various alternative asset classes and investment platforms.
- INVEST through one or more of the ever-expanding number of investment platforms.
The material in this blog is presented for informational purposes only. Millennium Trust Company performs the duties of a directed custodian, and as such does not sell investments or provide investment, legal or tax advice.
Millennium Alternative Investment Network® is a registered trademark of Millennium Trust Company, LLC in the United States.