How do interest rates affect your investments?
Understanding the relationship between interest rates and investments can help investors get to grips with why different types of investment react in different ways when rates change.
Here, we explore how interest rates affect bonds and equities - and why, although rising rates can be a sign of economic revival, they often aren’t good news for investors.
What interest rate movements mean for bonds
Bonds, which are IOUs issued by companies and governments looking to raise cash, are debt instruments, which means interest rate movements tend to have a greater impact on them than on equities.
Investors in bonds earn a regular fixed rate of interest, called a ‘coupon’. Once the bond matures, the original capital invested is paid back in full, provided the issuer hasn’t run into financial difficulties.
When interest rates fall, bond prices rise because the fixed rate of interest they pay becomes much more appealing to investors.
Short-dated bonds – those which are nearing maturity and will soon return capital to investors - tend to be less sensitive to interest rate movements than bonds with a longer duration. This is because over the long-term, it is more likely that interest rates will rise, negatively impacting bond prices.
Fixed income investors who want to sell long-term bonds before maturity may therefore find that they have to accept a heavily discounted market price if interest rates have risen substantially since they invested. This risk is not as great with short-term bonds, as there’s unlikely to be any significant change in interest rates over shorter term periods. Should rates start to move meaningfully higher, portfolios which are overweight in short-term bonds may therefore offer the potential to minimise losses.
How interest rates affect equities
Interest rates usually rise when a country’s central bank wants to control rising inflation, as persistently high inflation can have a negative effect on the economy.
Putting up interest rates mean that businesses and consumers are likely to cut back on their spending on goods and services, as the cost of borrowing is higher.
This can often be bad news for equities , prompting company earnings to fall and share prices to drop.
Some sectors tend to fare better than others when interest rates are increasing. For example, rising rates can make it easier for financial companies such as banks to profit from lending. This is because higher rates mean less of a squeeze on their net interest margin, which is a measure of the difference between the interest income they generate, compared to the amount of interest they pay out.
When living costs are very low, the more likely interest rates are to fall, so that borrowing costs will become cheaper, which helps encourage spending. This in turn boosts company profits, causing share prices to rise.
Market sentiment matters
It’s also important to remember that markets move based on sentiment, with interest rate decisions analysed in terms of what this means for the global economy. A change in interest rates can often result in an instant change in sentiment, triggering optimistic or pessimistic expectations of future stock returns.
For example, if investors believe a rate cut will prompt businesses to increase spending and investment, stock prices often rise in anticipation. Conversely, when a hike is announced, markets tumble in anticipation of earnings falling as businesses and consumers cut back on spending.
During periods when rates are rising, markets tend to fare better if increases have been signalled in advance and are in response to stronger economic growth, than if they are a reaction to a currency crisis or other economic problem.
However, even where an interest rate rise in one country signifies a strengthening economy, it can result in other countries losing their appeal for investors. For example, emerging market economies, which often have a large proportion of their debt denominated in US dollars, tend to suffer when US interest rates rise, as this debt becomes more difficult to service.