Learn how rising interest rates may affect the investments in your portfolio and which investment strategies may lower the risks and increase the potential for growth.
As an investor, it’s important to know whether interest rates are rising or falling. Why? Changes in interest rates impact the performance of stocks and bonds. Which way rates are headed, along with your goals and risk tolerance, may influence how you diversify your portfolio.
Let’s take a look at how rising interest rates may impact your investments and strategies to help sustain your portfolio in this type of economic climate.
Generally, bond prices and interest rates move in opposite directions—when interest rates rise, bond prices tend to decline. Think of it this way: Say, you have a choice of a $1,000 bond that pays 2% interest or one that pays 3%. All other things being equal, which would you choose? The higher interest rate can make the lower-yielding bond less appealing to investors, which causes the price to drop
Not all bonds react the same way to interest rate changes. Some are more sensitive depending on the type of bond or its quality. For example, corporate bonds typically have higher coupon (interest) rates, which generally make them less sensitive than U.S. Treasuries. This is because higher-quality bonds tend to be more sensitive to changes in interest rates. So, if you have a AAA-rated corporate bond, you may see a larger change in the price compared to a AA-rated bond.
Bonds with shorter durations (maturities) are usually less affected by rate changes as well. According to this chart from Charles Schwab, a 1% rise in rates could lead to a 1% drop in the one-year Treasury bill’s price. The longer the maturity, the greater the effect a rise in interest rates will have on bond prices. The same 1% rise in rates could mean a 5% decline in the price of a five-year bond or a 16% drop in the price of a 20-year bond.
One way to potentially help minimize the risks of rising interest rates is to create a bond ladder, which involves having multiple bonds with different maturity dates. This diversified approach allows investors to own a variety of bonds with a variety of maturities so when interest rates change, each bond will be affected differently. Additionally, as each “rung” on the ladder matures, you can purchase new ones with higher yields, assuming rates are still rising. You may also want to consider diversified bond mutual funds or exchange-traded funds (ETFs).
When interest rates are rising or if investors anticipate a rise, many will sell bonds or some of their bonds to avoid the fall in prices and buy stocks. This commonly results in stocks rising while bonds are falling. Like bonds, not all stocks react the same way to rate hikes. In fact, some sectors historically perform well during periods of rising interest rates. For example, banks typically have stronger earnings because they can charge more for their services. Rising interest rates also tend to favor value stocks over growth stocks because of the way many investors calculate a stock’s intrinsic value. Rising interest rates makes these investors demand more for their investment dollars, so they’ll commonly turn to stocks that have a history of earnings growth. Of course, past performance is not an indicator of future results.
However, over time, rising interest rates can have a negative effect on stock prices. Higher interest rates make it more expensive to borrow money. A business that doesn’t want to pay the higher cost for a loan may delay or scale back projects. This, in turn, may slow the company’s growth and affect its earnings. A company’s stock price generally drops when its earnings decline.
Also, rising rates increase margin rates or the rate in which traders borrow money to trade stocks. The higher rates make trading on margin less profitable, and many traders often cut back the amount of margin they use, which means there’s less demand for stock shares.
Finally, rising rates typically lead to a stronger dollar, which may put additional pressure on the stock prices of multinational companies because it becomes more expensive to do business in some countries.
As you review your portfolio, check to see which sectors your stocks are in. It could be a good idea to avoid being heavily invested in one particular area of the market. You may also want to consider diversified stock mutual funds or ETFs.
Financial markets and interest rates move in cycles, and no one knows for certain how long an upward or downward trend may last. A well-diversified portfolio may help you pursue your financial goals.