Key advantages may be found in these areas: wealth transfer, lending and investing.
We’ve been talking about low interest rates for the better part of a decade now. With the yield on the 10-year U.S. Treasury less than half of what it was after the global financial crisis, and the Federal Reserve (Fed) signaling its intention to keep policy rates at zero for the foreseeable future, the conversation won’t be changing anytime soon. That’s a headwind for your cash and bond portfolio—there’s no getting around it.
But we see tremendous opportunities in a low interest rate environment. They can be found in three key areas: lending, wealth transfer and investing.
Could you benefit from a boost in liquidity? The low rate environment makes it a great time to access liquidity. Here are our top ideas for the liability portion of your balance sheet:
Mortgages1—With rates so low, it may make sense to refinance your mortgage (floating or fixed), even if it was taken out in the last few years.
- Tax-aware borrowing—Consider maximizing the tax efficiency of past or future home purchase(s) with a tax-aware borrowing strategy. You can pay for a property in cash and then undertake a cash-out refinance2, with the proceeds used for taxable investments. In this way, interest on the loan is classified as investment interest, which is uncapped and can be deducted fully against your investment income. By contrast, the standard mortgage interest deduction is limited to interest on no more than $750,000 of acquisition debt.
Portfolio line of credit3—For access to liquidity, a portfolio line of credit offers a flexible solution that allows you to stay invested and helps meet your long-term goals:
- Bridge lumpy cash flow—You can use a portfolio line of credit to make quarterly tax payments, meet capital calls or make an expedient purchase. This is often a more efficient way than selling a portion of your investment portfolio for cash.
- Exercising stock options—Borrowing to pay the strike price and income tax due for the exercise of stock options can allow you to maintain a larger exposure to your stock.
- Business expansion—If you’re a business owner, a low rate environment is a good time to expand your facilities or invest in new capital equipment. A portfolio line of credit could offer low rate financing that typically has no setup costs. To boot, a provision in the 2017 Tax Cuts and Jobs Act allows business owners to expense 100% of the cost of many of these assets. However, the provision begins to phase out in 2023.
- Investment dry powder—A portfolio line of credit can finance time-sensitive, high-conviction investment ideas. In this way, you can avoid holding excess cash earning a negative real rate of return.
Wealth transfer opportunities
Transferring wealth makes sense in many different market environments, but low interest rates are especially conducive to so-called “freeze” wealth transfer techniques. In these scenarios, you’re giving a beneficiary the appreciation that will accrue to an asset over today’s interest rates. For transfer tax purposes, the asset is “frozen.” Essentially, lower interest rates mean lower hurdle rates4—making it relatively easier to transfer appreciation on wealth than it would be in a higher rate environment.
Here are five wealth transfer techniques you might consider:
Grantor retained annuity trusts (GRATs) — If you’re looking to transfer wealth while still receiving a payment stream for a period of years, you may want to consider a GRAT. GRATs are irrevocable trusts in which the grantor receives a series of payments back from the trust, but any growth above the hurdle rate is transferred to the next generation free of transfer tax. It can be particularly effective with concentrated positions and other holdings for which you expect outsized growth.
Intra-family loans — If you’d like to provide liquidity to your children without gifting the money outright, you may want to consider an intra-family loan. A chief appeal: An intra-family loan takes advantage of differences between potential investment returns and prevailing interest rates. The parent (or grandparent) lends money to family members in exchange for a note bearing interest at the applicable federal rate (AFR), which is typically lower than market interest rates. It’s an effective strategy to help the younger generation purchase a home or start a businesses.
Sales to irrevocable grantor trusts — Opportunities for attractive asset sale valuation may be found in sales to irrevocable grantor trusts. In this strategy, the grantor sells assets to an irrevocable trust in exchange for a note bearing interest at the applicable federal rate (AFR). The grantor may be able to claim that the assets (e.g., those of a closely held business) should be valued with a discount, given a lack of marketability and lack of control; if so, that would reduce the face value of the note received from the trust. So, you could potentially sell your $100 business to your trust for typically anywhere from $65 to $80. The trust usually makes interest payments annually, to the grantor, with a “balloon” payment at the note’s maturity, with any assets remaining in the trust available to benefit members of the grantor’s family.
Charitable lead annuity trusts (CLATs) — If you want to benefit charities and family members with the same strategy, consider a CLAT. In this “split interest” gift, during the term of the trust, annual payments are made to a charity, including a donor-advised fund or a private foundation. When the trust ends, any remaining assets pass to (or are left in trust for the benefit of) your family, free of transfer taxes. Using a properly structured CLAT during a year of outsized income, either due to the sale of a business or the payout of various forms of executive compensation, lets you align the charitable income tax deduction with the year that you can best use it. Meanwhile, payments to charity are spread out over many years.
Pre-transaction planning — Are you thinking about selling your business or taking it public? In part because of low interest rates, 2021 is likely to be an active year for M&A and IPO activity. If you’re contemplating such a transaction, you may want to pursue a strategy that could help move wealth to family members and charities well beforehand. Your financial and legal advisors should guide any decision to make a pre-transaction gift. Note that IRS regulations require a specific amount of time to elapse between gift transfer and transaction.
Low interest rates are putting certain portfolios under pressure, and additional drivers of return and defensiveness may be needed to meet your goals. Here is how we’re advising clients to navigate the current market environment:
Put excess cash to work. Holding cash in excess of what’s needed for regular spending, rainy day funds and near-term plans means you’re losing purchasing power over time. Click here for a framework you can use to determine how much cash you need to hold.
Consider alternative investments. Adding alternatives can help strengthen your portfolio by providing new sources of diversification and return. If you have a multi-year time horizon, now may be a good time to explore alternative investments in real assets—such as real estate and infrastructure, as well as private and direct lending strategies. Real assets can provide low or negative correlation to stocks, higher yields than government bonds, protection against inflation and a steady stream of income.
By any measure, interest rates are exceptionally low. What’s more, they’re likely to stay fairly low for a while. That means reduced yields on cash and bonds. But it opens up a wide opportunity set for lending, wealth transfer and investing. Your J.P. Morgan team can help on all three fronts, addressing the asset and liability sides of your balance sheet so you can make the most of today’s low interest rate environment. Reach out to your team to discuss how these strategies might help you reach your goals.
1 Mortgages apply to U.S. investors only.
2 A cash-out refinance is when a homeowner refinances a current outstanding mortgage or initiates a new mortgage on an unencumbered property, taking out additional proceeds above-and-beyond what they currently owe.
3 A portfolio line of credit is where borrowers pledge securities in an account and are free to trade in that account so long as they maintain the collateral levels to support the line of credit. Borrowers are usually charged an index -based variable interest rate. Repayment terms are flexible, with interest paid only on the amount borrowed.
4 The interest rates that apply to wealth transfer techniques are the applicable federal rates (which apply to intra-family loans and installment sales), and the §7520 rate which is used to calculate the present value of annuity payments for grantor retained annuity trusts [GRATs] and charitable lead annuity trusts [CLATs]. These rates are published monthly by the Internal Revenue Service.