Interest Rates' Impact on Portfolios
What are interest rates?
Interest rates are what someone pays for borrowing money or earns from lending it. They show up in various places, including savings accounts, mortgages, student loans, credit cards, government and corporate bonds. When rates are high, borrowing volume and business expansion decrease, and when rates are low, borrowing volume increases along with business expansion.
Who determines interest rates?
Central banks, like the Federal Reserve (the Fed), adjust the short-term interest rate to guide the economy. During periods of high inflation, the Fed may increase rates to cool down borrowing and spending, easing pressure on prices. During periods of economic stagnation or downturn, they may decrease interest rates to promote business expansion and consumption.
Only the short-term interest rate, known as the Federal Funds Rate (FFR) is controlled by the Fed. However, this rate ultimately decides all other rates in the broader economy. Other rates like those of mortgages and credit cards are determined by financial institutions, though their decisions are influenced by and move in the same direction as the FFR.
How do interest rates affect different investments?
Changes in interest rates ripple across almost every corner of your investment portfolio. They shape the cost of borrowing, how stocks are priced, and the value of bonds. It is important to understand how and why this happens to stay resilient through market shifts.
When rates rise, previously issued bond price go down, and investors move toward the new, higher yielding bonds. Bond prices work inversely. Compared to short-duration bonds, longer-duration bonds react more sharply to interest rate shifts.
For example, lets compare a 3-month bond holder to a 10-year bond holder. If rates go up, holding a 3-month bond means you won’t be exposed to the lower-rate for long and your capital will return shortly, meaning less investors will flee their position. Holding a lower rate bond for 10 years means you would be exposed to the lower rate for quite some time, increasing people’s motivation to close their position.
Stock valuations are also affected by interest rate adjustment, though in different ways. When rates rise, borrowing costs goes up, loans get more expensive, and people spend less. For businesses, this means less expansion, growth, and dampened profits. This can put pressure on their stock valuations as their financials can weaken and investors may pivot to safer assets. Conversely, when rates drop, companies can more easily borrow and expand. Investors may pivot away from lower yielding bonds and toward stocks, and dividend-paying stocks due to potentially higher yields.
It is important to note that assets like commodities, currencies, and real estate are also influenced by interest rate adjustments, but the clearest effects show up in the market prices of bond and stock prices.
Rate Environment | Impact on Bonds | Impact on Stocks |
Rising Rates | Existing bond prices fall while newly issued bonds offer higher yields. | Borrowing costs increase, particularly growth companies may feel pressure. |
Falling Rates | Existing bond prices rise while newly issued bonds offer lower yields. | Borrowing costs decrease, potentially supporting a higher valuation. Growth companies experience less pressure, and dividend yields may seem more attractive. |
Volatile Rate Environment | Bond prices fluctuate | Dividend-paying or defensive stocks may hold up better. |
Final words
Interest rate adjustments typically occur to slow down or boost the economy. Overall, rising rates may put pressure on the market prices of both stocks and bonds and falling rates provide support. Knowing why rates change and how your portfolio reacts is important when making investment decisions. Reach out to one of our wealth managers for more information on rate adjustments and portfolio outlook.
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