Interest Rate Hike: A Double-Edged Sword

I am sure that a hike in interest rates – which finally happened on Wednesday night – has been on a lot of investors’ minds in recent months.

As you may have already heard, this is the first rate hike by the Federal Reserve in the U.S. since 2006, with the American central bank raising its benchmark interest rate target from a 0-0.25% band to a 0.25-0.5% band.

Let’s look at what this might mean for companies and investors.

Interest rate hikes are usually good for banks. We have three listed on the Singapore stock market, namely, DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX: O39), and United Overseas Bank Ltd (SGX: U11).

Banks can benefit from an interest rate hike because they can charge their customers higher interest rates on loans which lead to an expansion in Net Interest Margins (NIMs). NIMs are the biggest drivers of revenue for all three of the Singapore-listed banks.

However, an increase in interest rates may also cause Non-Performing Loans (NPLs) to rise. This happens because companies or individuals, especially those who are already heavily indebted, can no longer afford to service their loans. As such, it is important that the banks have been – and will be, going forward – careful when lending money out.

The next group that are likely to be affected by an interest rate hike are the real estate investment trusts (REITs). I say this because REITS are in essence leveraged property investors that usually carry a substantial amount of debt on their books.

But, with an anticipation for a possible interest rate hike over the past few years, many REITs in Singapore have moved to ensure that they have at least some fixed rate debt on their balance sheets. This should give investors some reassurance that distributions for many REITs shouldn’t be severely impacted, at least over the short-term.

Lastly, I want to address a specific group of investors and that is, value Investors. Usually, one of the criteria used by value investors when analyzing a company is to look at debt. Some value investors I know of only buy companies with zero debt on their balance sheet – in this instance, a change in the interest rate environment probably has little effect on their investments.

Some other value investors though, might be more relaxed and would allow companies in their portfolio to have some debt on their books (there is actually a theory on optimal levels of debt). For such investors, they may need to decide if the change in interest rates is something to worry about as companies with debt may find their bottom-lines under pressure.

At the end of the day, as investors, we can only use the information that are currently available to us to make informed investment choices. After which, it is important to follow our companies and ensure that there are no changes to the investment theses. If there are indeed changes, then the investments would require reevaluation.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Esjay owns shares in Oversea-Chinese Banking Corporation and United Overseas Bank.