There are those who think that interest rates are going lower. They may be right. But this column is for those other folks.
The ones who feel that the only place for interest rates to go from here is up.
While many of us follow the prime rate that is tied to a variable rate mortgage (i.e. prime minus 0.5%), fewer of us follow the 10-year Government of Canada bond rate. This 10-year rate is now down to 1.28%, virtually the lowest rate in Canada’s history.
When any financial data appears to be at an extreme level, there is usually a rare financial opportunity associated with it. Here are three possible ways to take advantage of this rare situation.
Consider taking the cash instead of the pension – it could be worth $400,000+ more
If you are in a defined-benefit pension plan and getting close to retirement, make sure you review whether you are able to take your pension “in cash.” This isn’t something that everyone should do, but the historical low interest rates create a rare opportunity for your pension to be worth a lot of money.
We have seen several people at large quasi-governmental energy providers with pensions that are presently valued at $2 million with today’s low interest rates.
Let’s assume this pension is based on a 65-year-old male, with a 60% spousal survivor pension. What happens if rates go up? You might think that this person who worked and contributed to their pension for 40 years wouldn’t care about interest rates, but the impact would be sizable.
If mid-term interest rates went up 2%, this pension that is worth $2 million today would be worth $1,580,000, according to Toronto-based actuary Daniel Kahan.
So retiring today and taking the pension would provide over $400,000 in extra cash than if our pensioner retired when rates were 2% higher.
The message here is that if you are considering retirement with a pension, it is always worth knowing the commuted value of your pension. If you were ever considering taking the commuted value in cash, now is probably the time to do it.
Take the fixed-rate mortgage – it only costs about 0.5% more
The variable vs. fixed-rate discussion could go on forever. I know that, historically, variable-rate mortgages have done better for consumers than fixed. In my opinion, now is not one of those times.
If you shop for the best rates on either five-year fixed or variable mortgages today, you can usually find a gap of just 0.54%. For example, you might get as low as 2.05% on a variable-rate mortgage, and as low as 2.59% on a 5 year fixed.
A lot can change in five years, and by taking a variable rate, you are getting only a 0.54% premium for taking this risk.
To oversimplify things, if short-term rates don’t change for a full year, but went up just 0.75% (to a rate that is still near historic lows) and then kept that rate for four years, you would still be slightly better off financially with a fixed rate.
Keep in mind that as recently as 2007, the bank prime rate was 3.65% higher than it is today. It took just 18 months for the rate to drop 4.25% from 2007 to 2009. If you are in a variable-rate mortgage, you don’t want to even think about a 4.25% increase in 18 months. At a real “cost” today of just 0.54%, I think paying this extra 0.54% for the ability to lock in a fantastic rate for five years may be a significant financial win today.
Consider buying an ETF that shorts long-term bonds
In 2014, the iShares 20+ Year Treasury Bond was up 28%. It was up another 8% in January. This isn’t a normal return for a bond ETF. The reason it did exceptionally well is that long-term bond yields had dropped so low.
When a bond investment does that well, you have to be a little wary of what will happen next.
If one believes that the U.S. long-term interest rates are truly near the bottom today, one of the best investments would be something like the ProShares Short 20+ Year Treasury ETF (symbol is TBF). This ETF essentially works the opposite of the iShares ETF. The ProShares Short ETF was down roughly 25% in 2014.
Of some interest, this ETF can also be used as something of a hedge against the stock market. Certainly one of the biggest fears of the stock market is a return to rising interest rates. In that event, this ETF will perform very well at a time when the stock market is not.
We don’t know if we are truly at the bottom for long-term interest rates, but we do know that we are currently outside the long-term historical norms. Just as technology stocks in 1999 had valuations outside of long-term historical norms, and today’s oil price declines have now reached historically significant levels, today’s long-term interest rates likely represent a rare opportunity for significant wealth creation – if you have the guts to move in the opposite direction of the herd.
Reproduced from the National Post newspaper article 4th February 2015.