Interest Rates and Investor Decisions: The Long and Short of It

IMF Blog, September 13, 2011

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Long-horizon institutional investors generally do not look at differences in interest rates among countries when deciding where to invest.
The primary factors these long-term investors consider are:
- good and stable growth prospects,
- low country risks—including political and economic stability,
- a stable exchange rate.
Interest rates (short-term, long-term, real, and nominal) generally did not affect institutional investors’ allocations to equities or bonds.

Institutional investors:
- Typically have long investment horizons with obligations that often stretch out over decades.
- Focus on long-run returns and invest their own cash rather than borrowed money.
- Show little response to interest-rate differentials across countries.
Leveraged investors (not directly covered by the research):
- Include hedge funds and carry traders who borrow money to invest.
- Are likely more sensitive to interest-rate differentials because borrowing rates are a direct cost rather than an opportunity cost.
- Face increased risk through leverage, making portfolios more sensitive to underlying fundamentals, including interest rates.

Relative size:
- Institutional investors examined hold by far the largest amount of total assets to invest—over $70 trillion dollars.
- Total investable assets of leveraged investors are much smaller, probably around one-tenth of the assets of institutional investors.
Market behavior and volatility:
- Leveraged investors trade much more frequently, moving money in and out of markets and countries to seek short-term opportunities.
- Their trading behavior can have a large impact on market volatility despite smaller asset size.
- In times of market turmoil, leveraged investors may be forced to sell to avoid losses that exceed initial investment, while long-term investors may be more inclined to ride out downturns.

Current behavior:
- Many institutional investors are accepting lower returns without moving funds to higher-interest, higher-risk countries or into other riskier domestic assets.
Potential future behavior if low rates persist:
- Low interest rates can hurt the financial position of institutional investors that need to earn a certain minimum return (for example, pension plans with promises based on much higher expected rates of return).
- The longer the low interest rates prevail, the greater the pressure for these investors to “search for yield,” which could increase sensitivity to interest-rate differentials over time.
Long-run outlook:
- Despite this risk, the long-run story is expected to remain: long-term investment flows are likely to be dominated by long-run institutional investors who prioritize growth prospects and country risks over interest-rate differentials.

Total assets held by institutional investors examined: over $70 trillion dollars.
Estimated total investable assets of leveraged investors: probably around one-tenth of the assets of institutional investors.

Source: Interest Rates and Investor Decisions: The Long and Short of It (Erik Oppers, September 13, 2011).