Oran Hall | The importance of interest income
Interest income comes primarily from bonds, debentures, and savings and deposit accounts at financial institutions authorised to operate such accounts. Although interest rates have fallen – and sharply, too – interest income is still important to many people.
Interest rates on deposit accounts are for fixed terms and tend to be higher on savings accounts. Although the rate on deposit accounts is fixed for the term of the deposit, withdrawing funds prematurely may result in the rate being reduced. Some see this as a penalty, but the financial institutions would more likely see this as paying a rate more reflective of the rate applicable to the new term of the deposit.
The interest rate on deposits varies depending on the term – generally, the longer the term, the higher the rate. Savings accounts do not afford that flexibility, and savers should be careful not to withdraw from their savings close to the time interest is to be added to their accounts. On the other hand, adding significant funds to a savings account close to that time will not magically cause a significant amount of interest to be credited to the account.
Generally, interest is paid on bonds and debentures at six monthly intervals, but some issues do pay interest quarterly. A significant advantage of interest income, therefore, is that the time when it is to be paid is known. In most cases, also, the amount to be paid is known.
Interest on variable rate instruments is different: the rate is determined on the basis of a pre-determined formula, such as the rate of a government short-term debt instrument, like a treasury bill, plus a stated amount of percentage points above that rate.
The big advantage of this approach is that the rate is generally in sync with the level of interest rates in the financial system at that time. Contrast this with fixed-rate bonds and debentures which remain fixed for the full term of the instrument.
Fixed-rate instruments thus generate the same level of cash flow for the term of the instrument. This could prove helpful for planning, but it puts the holder of the instrument at a disadvantage in the sense that the real value of each dollar received declines as inflation – the sustained movement in the general level of prices – increases. So the same sum is received every time interest is paid, but it cannot pay for the same amount of goods and services as before.
Another important feature of fixed-rate instruments is that the same sum is paid regardless of the price of the instrument. For example, if the instrument bears a rate of 10 per cent at the time of issue, the holder of the instrument receives $10 for every $100 of the face value and also receives $10 for every $100 of face value regardless of the price an investor pays, be it $95 or $110 for each $100 of the instrument.
It is important for people who depend on bonds as a source of retirement income to organise their portfolio in such a way that interest income flows to them at different times to ensure a steady flow rather than being concentrated, thereby leaving some periods without any inflows of income.
Similarly, as much as possible, the maturities of the bonds and debentures should be such that they are spread out so that the principal sum at maturity can flow to them to match their requirements, thereby obviating the need to sell prematurely.
It is useful to own instruments that generate interest income because they do not lose value as much as ordinary shares and other assets which appreciate do. A reliable flow of interest income can also serve to generate some return on a portfolio even in times when the negative price movements of some assets threaten to move the return of the portfolio into negative territory.
Apart from the corrosive effect of inflation on interest income and principal, there is the risk that although the issuers of bonds and debentures contract to make interest and principal payments, it is still possible that serious financial difficulties could lead to these commitments not being kept.
To protect themselves against these risks, investors should take care to invest in high-quality corporate debt issues. Those investing in debt issues of governments should also pay attention to quality and bear in mind that instruments that pay higher returns are generally more risky.
I doubt we will ever see interest rates at the dazzling levels they once were, but interest income still has value. The need to generate higher returns need not drive investors to expose themselves to more risky instruments in preference to the lower-yielding but safer interest-bearing financial instruments.
- Oran A. Hall, principal author of ‘The Handbook of Personal Financial Planning’, offers personal financial planning advice and email@example.com