Are interest rates important for investing?
Given the media’s constant obsession with interest rates, let’s find out how important they really are when it comes to investing
UNLESS you’ve been living under a rock, you would have seen the news about the US Federal Reserve’s latest interest rate decision.
On Dec 18, the central bank announced its third consecutive rate cut, lowering the benchmark rate to a range of 4.25 to 4.5 per cent.
Chairman Jerome Powell also hinted that 2025 will likely see another two rate cuts, down from the four originally expected in September.
His comments were met with disdain, triggering a sharp sell-off in the stock market.
The sharp reaction tells you a lot about the stock market today.
Every US Fed decision has been closely tracked by news outlets, with investors hanging on every word the central bank utters. These clingy investors also attempt to find meaning behind Powell’s words and body language, all in an attempt to gauge the future direction of interest rates in the coming year.
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The attention is relentless.
Yet, amid the circus, it’s worth asking: Should interest rates play a central role when you invest in stocks?
The answer is, it depends.
Some sectors, companies and asset classes are far more sensitive to interest rate changes than others.
Here’s a quick overview of how interest rates can impact specific industries or businesses.
Banking on higher interest rates
Banks are the backbone of any economy, playing a crucial role in enabling individuals and businesses to borrow money for purchases and investments.
The success of these financial institutions is closely tied to interest rates, as their core business involves accepting deposits and lending them out to earn net interest income.
When interest rates rise, banks can charge higher rates on loans, leading to an expansion in their net interest margin (NIM).
This trend is evident in the performance of local banks such as DBS and OCBC.
From 2022 to 2023, DBS saw its NIM surge from 1.75 per cent to 2.15 per cent, driven by higher interest rates. Over the same period, net interest income also jumped nearly 25 per cent year on year, reaching S$13.6 billion in 2023.
Similarly, OCBC NIM’s rose from 1.91 per cent in 2022 to 2.28 per cent in 2023. Singapore’s second-largest bank saw its net interest income grow 25.5 per cent, crossing the S$9.6 billion mark.
But what happens when interest rates fall?
Investors often worry that they could negatively impact banks’ net interest income and, in turn, their net profits.
Yet, lower rates are just one factor to consider.
Banks can also boost their non-interest income, such as fees, to offset a decline in net interest income.
For example, DBS saw a 27 per cent year-on-year increase in fee income for the first nine months of 2024, reaching S$3.2 billion, while OCBC’s non-interest income rose by 23 per cent year on year to nearly S$3.8 billion.
High interest rates can also dampen borrowing, which in turn slows loan growth.
Case in point: as at Sep 30, 2024, DBS’ loan book remained flat year on year, while OCBC’s loan book grew by just 2 per cent.
This could change in 2025.
If interest rates decline in 2025, it could provide a boost to loan growth.
Reits hobbled by interest rates
Real estate investment trusts (Reits) are a popular choice for income investors due to their requirement to distribute at least 90 per cent of their earnings as dividends.
This rule makes Reits an attractive option for those seeking consistent income through steady payouts.
However, investors should be aware that this asset class is sensitive to interest rate changes.
Reits rely on debt to purchase the assets they own, thereby maintaining a certain level of debt on their balance sheets.
Hence, rising interest rates can significantly impact their finances.
Need some examples?
For the first half of fiscal 2025, Mapletree Logistics Trust experienced an 8.8 per cent year-on-year increase in borrowing costs.
Similarly, CapitaLand Ascendas Reit saw a 14.3 per cent surge in net finance costs for the first half of 2024.
But Reit managers are not standing idle.
One strategy they use to mitigate rising finance expenses is capital recycling – refreshing their portfolios through property divestments and acquisitions.
Mapletree Logistics Trust, for example, completed eight divestments and acquired three yield-accretive assets in its current fiscal year.
Additionally, positive rental reversions and asset enhancement initiatives (AEIs) can help Reits generate organic rental income growth, counteracting the negative impact of higher interest rates.
For instance, Aims Apac Reit reported a 16.9 per cent positive rental reversion for the first half of fiscal 2025, while Frasers Centrepoint Trust recently completed an AEI for Tampines 1 Mall, generating a tidy return on investment of more than 8 per cent.
Heavily indebted businesses
Businesses that carry significant debt are especially vulnerable to changes in interest rates.
Investors in these companies should pay close attention to how rising interest rates affect their operations, as well as whether management is taking steps to reduce debt or refinance loans at more favourable rates.
Take Singtel as an example.
As at Sep 20, 2024, the leading telecom company had a total debt of S$11.6 billion. Singtel’s finance expenses for the first half of fiscal 2025 accounted for close to a third of its operating profit.
Wilmar International is in the same camp.
By Jun 30, 2024, the agribusiness giant had US$7.1 billion in cash and equivalents alongside US$26.8 billion in debt, leaving it with a net debt position of US$19.7 billion. For the first half of this year, finance expenses consumed nearly a quarter of the group’s gross profit, surpassing even its administrative expenses. With substantial debt and high interest costs, both Singtel and Wilmar’s profits are more sensitive to interest rate fluctuations than those of companies with low or no debt.
Debt-free businesses
On the other hand, debt-free businesses have the advantage of being unhindered by the challenges of a high-interest-rate environment.
These companies typically generate consistent free cash flow, allowing them to avoid relying on debt financing.
Sheng Siong serves as a great example.
As at Sep 30, 2024, the supermarket chain held S$350 million in cash and had no debt. It also reported a solid free cash flow of S$141.3 million for the first nine months of the year.
Another example is HRNetGroup, a human resource recruitment firm. As at the middle of 2024, HRNetGroup had S$246.8 million in cash and no borrowings. In addition, the company generated a positive free cash flow of S$17.2 million for the first half of the year.
While being debt-free is a clear advantage, it’s just one factor to consider when evaluating a business.
Though these companies are not reliant on banks, other elements also play a crucial role in their ability to grow both their revenue and profits.
Get smart: It depends
The examples above illustrate how interest rates can affect various businesses and sectors.
As an investor, it’s important to evaluate how interest rate changes impact the stocks in your portfolio.
With this understanding, you can adjust your allocation or make changes as needed. However, remember that interest rates are just one factor to consider when choosing investments.
Before making any investment decisions, it’s essential to take a holistic look at the business’s overall appeal.
The writer owns shares of DBS. He is portfolio manager of The Smart Investor, a website that aims to help people invest smartly by providing investor education, stock commentary and market coverage
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