Should you be reducing your debt?
Should you be paying off your bond rather than investing in unit trusts? Many commentators have stressed that the most obvious thing to do with your year-end bonus is to hit your home loan. Rising short-term interest rates and a five year bull market in equities have left many investors wondering whether their monthly unit trust debit order should not go into their bond instead. David Crosoer from Glacier Research argues that investors need to stick to their long-term plan (that still includes their unit trust investments), and having debt in an inflationary environment can make sense.
Some of us have no choice but to aggressively pay off our debt. We’ve taken on too much debt relative to our income, and we need to reduce our debt to more manageable levels. Here it makes sense to reduce your debt. But some of us have things under control. Should we also be reducing our debt aggressively?
In a rising inflationary environment it generally pays to have debt. This is because inflation typically increases faster than commentators expect, so the cost of your debt actually falls in real terms because interest rates don’t rise fast enough. So far, short-term interest rates have kept pace (just) with increasing inflation. The Reserve Bank has raised short-term interest rates eight times since June last year. But inflation has also increased by approximately 4% over the same period. So in real terms (i.e. after inflation) you’re still paying the same amount with the Repo rate at 11% that you paid between April 2005 and June 2006 when the Repo rate was at 7%.
The real price of debt has not (yet) increased. You’d want to reduce your debt aggressively if you felt that the real price of debt was going to increase. This is most likely to happen if inflation falls faster than most commentators think. Holding debt in a falling inflationary environment is expensive if the fall in interest rates lags the fall in inflation (because the real price of debt will increase). This will be the case if the Reserve Bank underestimates the fall in inflation.
It seems more likely that the Reserve Bank will underestimate the increase in inflation. Most models underestimate an increasing trend as they are inherently backward looking (based on past data). It might also become politically difficult for the Reserve Bank to act hawkishly on inflation, even if their models were correctly estimating it. If you are bearish on inflation (i.e. you think that inflation is not going to fall back into the band as quickly as commentators suggest) then your debt (in real terms) might actually get cheaper.
Many South Africans already have too much debt, and the fact that the real price of debt might get cheaper in future won’t help them much. Instead, rising inflation is making them materially poorer (the cost of everything else has increased), and paying off their debt has become more difficult without cutting back on other expenditure. These individuals need to cut back on current expenditure (i.e. cut non-essentials) or future expenditure (i.e. cut other investments) or do both.
Investors who have a sustainable long-term plan need not do anything drastic this festive season. Your debt has not gotten more expensive in real terms, and there is a reasonable chance that it might get cheaper. Diverting resources away from your long-term strategy to reduce a liability (your debt) that might get cheaper does not necessarily make sense. In a rising inflationary environment debt might be the one liability you might want to have.
