The markets and financial media are obsessed with interest rates these days.
Sometimes it seems that the daily casino yo-yoing of share prices is purely driven by comments from leading central bankers such as Mark Carney in the UK or Janet Yellen in the States.
So when Carney hinted last week that UK rates could rise sooner than expected – perhaps in 2014 – a new round of market chatter and speculation was triggered.
But there’s one point that hasn’t had much coverage: rising rates could deliver a nice boost to one of the UK’s largest companies – BT (LSE: BT.A).
Will rates actually rise?
Before I start on BT, I’d just like to consider if rates really will rise this year.
When Carney hinted that a rate rise would come soon, the price of shares and bonds went down a bit. Carney said yesterday that he was surprised at that reaction. But when people delved into the latest minutes of the Monetary Policy Committee (MPC) yesterday, it seemed that a rate rise should not be seen as a certainty this year.Some MPC members still think the economy has plenty of spare capacity, which means higher inflation is not likely to rear its ugly head. So bonds went back up again.
For what it’s worth, I don’t think interest rates are going up. There’s certainly not much inflation about at the moment according to the official statistics. This is borne out too if you go to the supermarket, the petrol station or read your latest electricity bill. Prices are not going up much. In fact, lots of them are going down.
Rising interest rates have a silver lining
But what if interest rates do go up? If they do it probably won’t be by much. I can’t see rates of 5% any time soon. If rates are going up on the back of an improving economy, bond prices will probably fall a bit. However, the stock market may fare better and some shares might do very well. One of those shares is BT.
BT is certainly prospering at the moment. Its fibre optic broadband and move into televised sport is paying off. The company is generating shedloads of cash and is increasing dividends at 15% for the next couple of years. But there’s one thing that worries even the bulls of BT shares – its pension fund deficit.
Final salary pension funds are a very dry but important subject. The promise to pay employees a proportion of their final salaries in retirement is a wonderful deal for staff. But it can be a serious burden for employers.
At the end of March, BT’s pension fund had a £7bn hole in it (it had assets of £40bn and liabilities of £47bn). If you are a shareholder, this pension fund hole is like a big lump of debt. More importantly, it has to be paid before you get your dividend. BT is paying an extra £295m a year into the fund for the next seven years to try and plug the hole. Big pension fund deficits mean lower share prices.
Final salary pension funds have been one of the biggest victims of low interest rates. That’s because of the way companies have to account for these pension schemes. The promises to pay pensioners in the future have to be given a value in today’s money.
That’s done by a process called ‘discounting’. Let’s imagine that a pension fund’s total liability in the future is £1bn. If we want to value that sum in today’s money, we have to use a discount rate. So if all the liabilities crystallised in ten years’ time – they won’t – you’d discount the £1bn liability at 2% interest a year for ten years.
With such a low discount rate, the liability in today’s money will be relatively large, but if the discount rate is 4%, the ‘today’s money liability will be smaller.
The discount rate is driven by interest rates, and as interest rates have been kept low, BT’s pension fund hole has been getting bigger. That £7bn hole reduces the value of BT shares by 88p per share.
But if interest rates go up then the deficit in BT’s pension fund could get smaller. For every 0.25% increase in interest rates, BT’s liability goes down by £1.6bn, and its equity value increases by 20p per share. Yes, interest rates will affect the values of bonds in the pension fund, but probably not by as much to offset the reduction in the liability.
BT shares have been on a good run over the last few years but I think there’s still more to go for. Some people may worry about it spending too much on televised football rights, but I think that risk is overplayed. Its fibre network gives it lots of advantages of Sky, while BT can make lots of money on broadband subscriptions with football. The shares are not desperately expensive on 13.4 times projected earnings and a growing dividend yield of 3.2%.
And if you believe interest rates are going up, the pension fund provides another boost.
• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.
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