The Impact of Interest Rates on Investments
3 min read
Diverse investments respond differently to increasing interest rates. Higher-quality bonds with longer “durations,” (the period remaining until they mature and return their capital to investors), are generally less susceptible to changes than shorter-term ones.
Low interest rates make borrowing money cheaper, encouraging consumer and business spending and investment activity and driving asset prices higher. Conversely, when interest rates increase consumers become more reluctant to spend which in turn slows economic growth.
Stocks and Equities
The stock market responds strongly to decisions by the Federal Reserve regarding interest-rate decisions, which in turn can influence bond prices. The Fed sets the federal funds rate – this interest charged by depository institutions like banks, credit unions and savings and loans when borrowing money overnight from each other – which ultimately influences bond prices.
Rising interest rates tend to reduce both consumer and business demand as the cost of financing rises, which in turn can hurt companies with lower earnings and stock prices, prompting investors to shift away from stocks into bonds instead.
However, a decrease in inflation could make stock valuations appear more reasonable and thus increase equity investments. Investors can limit losses by diversifying their portfolio with companies from various industries and sectors in order to lessen the impact that an economic downturn may have on overall returns.
Bonds
As interest rates increase, investments become less desirable due to increased marginal costs for investing each additional unit of capital – which may impact individual investments differently.
Bond values typically decrease when interest rates rise, as their fixed interest rate becomes less appealing compared to newly issued bonds with higher rates. This can result in capital losses for individual investors and bond funds who regularly buy and sell underlying holdings.
Low interest rates allow individuals and companies to borrow cheap money to spend and invest, helping stimulate the economy. When rates rise, borrowing becomes more costly for most companies (with exception of financial sector). Rising rates also mean future cash flow is valued at higher discount rates which reduce current stock prices and earnings – effects which investors must be mindful of when selecting portfolio components.
Cash
Long term, even when earning modest interest rates, one’s purchasing power will erode due to inflation. A $100,000 investment earning only 4% in 18 years would only be worth $10,150 after taxes and lost purchasing power due to inflation.
An increase in interest rates can put homeowners with mortgages under stress by increasing their monthly payments. A rising rate also reduces profitability for businesses looking to borrow funds, potentially hindering or slowing expansion plans.
As a general guideline, it’s recommended that investors allocate 2-10% or 6-12 months of expenses as cash investments in their portfolio. It is important to carefully consider both the advantages and disadvantages of holding too much cash as too much could depress returns in bull markets while hinder opportunities during market busts due to investors seeking risk-free returns instead of seeking potential gains.
Mutual Funds and ETFs
Mutual funds and ETFs offer great ways to diversify your portfolio, yet each differs significantly in several key respects.
ETFs typically generate lower capital gains than mutual funds because purchases and sales of fund shares through ETFs are made via brokerage accounts instead of directly with the fund company, eliminating much of the required paperwork-recording your details, verifying addresses, sending documents etc.
As noted previously, mutual funds typically trade only once daily on the New York Stock Exchange (NYSE). Conversely, ETFs can be bought and sold throughout the day allowing you to quickly respond when interest rates change quickly. Furthermore, ETFs tend to have lower costs due to passive management versus active management strategies used with mutual funds which frequently change holdings.
