Why higher interest rates could be good news for BT

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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  • Stephen360

    Re your comments re interest rates, they won’t go up before the election otherwise any chance of this government’s re-election goes out of the window bearing in mind peoples debt commitments at current low interest rates and the fact that they have been suckered into buying houses at top prices in exchange for low interest rates, the markets made good use of that one.
    The real fun will start after the election when house prices come down, interest rates go up and everybody realises how stupid they’ve been. What’s more, the government knows this, it has been they who have encouraged this overpricing in exchange for an economy uplift. But that won’t come out until they are back in government.l

  • Alec

    Cameron, Osborne and Carney will continue to rig the market right up to the election in 10 months’ time. The twenty eight million savers and pensioners who have been robbed of more than 350 billions pounds by zero interest rates, funding for lending, help to buy and of course the “Granny” tax have long memories and all those reckless mortgage borrowers will finally see the consequences of their rash gambling. Remember, the house price bubble is the result of paying zero interest rates to savers and absolutely nothing to do with the shortage of properties. Interest rates control the market and the market has not been allowed to work as a deliberate policy of this government.

  • CaptainPeacock


    Fantastic SUPERB Post – I could not of written it better myself – YOU are on the ball 100% CORRECT.

    RE: ”There’s certainly not much inflation about at the moment according to the official statistics.”

    Phil – you are having a laugh aren’t you?

    You believe the lies of ”official statistics” just look at the INCREASE in the cost of living since these Muppet’s in power brought rates to virtually ZERO, its absolutely criminal – end of.

  • Warun Boofit

    I agree with previous comments except inflation and I dislike Cameron and Osborne and all polticians and civil servants as much as anyone else (I would sack them all) but I will probably vote for them yet again unless I throw a wobbler and vote for Nigel. The alternative is Miliband and his bunch of cretins and look what they did last time they were in power so whatever stupid decisions Cameron makes he has to be better than Labour. Food and fuel costs are lower today than at any time in the past 30 years. I feed a family of four for £10 a week and thats eating good food not crappy tins of Lidl/Aldi brand beans and their bread which tastes like cardboard , our food may be past its sell by date but its fillet steak and I like it, I could never afford that in the olden times. Diesel and petrol cost way more in the 70s and 80s than it does now in real terms, the danger to our economy is deflation not inflation.