There has been a lot of talk about interest rates lately, leading to some uncertainty in various parts of the market, but how exactly do these rates affect your investment strategy?
In the U.S., the Federal Open Market Committee raised interest rates for the first time in over a year in December 2016, followed by another raise in March 2017 and estimates that rates will increase again soon. Those rates are felt around the world and affect global investments, exchange rates, and more.
Effect on Bonds
The general rule is that as interest rates increase, bond prices decrease. New bond buyers will likely earn more interest initially, but current bond owners will see their investment decline over time as bond prices are lowered to appeal to more investors.
Although bonds tend to be more predictable, as interest rates rise, that predictably will likely turn to delivering small or negative returns. The current combination of ultra-low returns and imminent interest rate increase makes for a less-than-ideal time to invest in bonds.
With that in mind, many investors are jumping ship and looking for other places to put their money.
Move Towards Equities
Many experts have predicted that as interest rates rise, people will move away from bonds and towards equities. There are pros and cons to this approach. Equities lack many qualities that make bonds so desirable for a strong portfolio, including capital preservation, predictable income, and low correlation to equities. Equities are much more volatile to capital preservation, so although they will likely increase in value over the long term, the short term can be a little more turbulent.
However, with recent rate changes, the value of equities hasn’t generally decreased as rates have increased. This will likely not always be the case, but it has been advantageous for investors up to this point.
In regards to stock prices, higher interest rates tend to have a negative affect on stock prices. There are exceptions to this rule, but it seems to be the general trend. This is likely because higher interest rates mean companies have to spend more money on their day-to-day costs and investments, which can cut into their quarterly earnings and lead to decreased performance.
A rising interest rate environment brings unique risk to investing. Even experienced investors might find it difficult to predict how stocks will do in a changing environment, meaning that it is even more important to consult with a financial advisor about your personal investment situation.
In general, a diversified portfolio protects against much of the risk of high interest rates. However, if you already have a portfolio with a large amount of equities, moving away from bonds and towards more equities won’t do much for your overall profits. Instead, consider investing in something else, such as high-yield bonds, which are less susceptible to interest rates, or real assets like a private mortgage fund.
Investors who don’t rely on income in real time have a few more options. They can invest in “market-neutral” hedge funds to trade debt or equity securities, or go the route of structured products like principal protected notes, which tend to carry more credit risk but can be more consistent in the long run.
The current high interest rate environment creates a unique environment for investing, but with careful planning and research, profits can still be made.