For many Americans living through the economic recession of the past several years, dealing with the affects of interest rates has become as inevitable as death and taxes.
The rise and fall of interest rates is one of the biggest factors influencing the economy, financial markets and our daily lives. That’s why it is important to have a basic understanding of how interest rate changes could affect not only your wallet but also your investment portfolio.
Simply put, interest rates help control the flow of money in the economy. Typically the Federal Reserve lowers interest rates to jump-start the economy. Lower interest rates mean consumers may be willing to spend more money and incur more debt. This stimulates the economy in a variety of ways, including increased revenues from products sold to the consumers and taxes generated from those sales. Investors, on the other hand, have a different perspective.
For bond investors, as interest rates fall, the prices of previously issued bonds tend to rise. The new issues are offered at lower, less appealing rates. That makes bonds with higher interest rates much more desirable and that much more in demand. On the other hand, those who plan to hold their bonds to maturity aren’t really affected by falling rates, with the exception of reinvestment risk.
One way issuers may take advantage of falling rates is by calling their outstanding bonds and issuing new bonds at lower rates. This can hurt those whose bonds have been called because they can’t reinvest at the rate they were previously receiving. To offset that risk, it’s important to make sure you don’t have too many callable bonds in your portfolio. Your fixed-income investments should be diversified to withstand rising and falling rates.
For stock investors, falling interest rates tend to have a positive impact on the stock market, especially stocks of growth companies. The companies that tend to borrow money to finance expansions also tend to benefit from declining rates. Paying lower interest rates decreases the cost of their debt, which may positively affect their bottom line. The stock prices of those companies may rise as a result, driving the market in such a way that prices of other stocks may follow suit.
When the Federal Reserve decides to raise interest rates, its goal is usually to slow down an overheating economy. Interest rates tend to affect the economy slowly ñ it can take as long as 12 to 18 months for the effects of the change to permeate the entire economy. Slowly, the cost of borrowing increases, banks lend less money and businesses put growth and expansion on hold. Consumers may begin to cut back on spending because they realize they don’t have as much disposable income as they once did. This reverses the effects that lower interest rates had on the economy and, again, investors are affected differently.
For bond investors, when interest rates shoot up, the demand for bonds with lower interest rates typically falls, which decreases their value. That’s because new bond issues are offered at higher rates.
For stock investors, depending on the current market environment, rising interest rates can have a positive or negative impact on the stock market. In some cases, rising rates can send jitters through the market, resulting in falling stock prices. In other cases, the stock market will respond favorably.
In addition, rising interest rates may affect certain industry groups more than others. For instance, because growth companies borrow money in order to expand, rising interest rates increase the cost of their debt, which in turn decreases profit (or increases loss). As a result, the prices of their stocks may fall.
If you’re interested in learning more about what changing interest rates mean for you, a financial advisor can help you better understand the effects interest rates may have on your portfolio.
Wells Fargo Advisors, LLC, Member SIPC, is a registered broker-dealer and a separate non-bank affiliate of Wells Fargo & Company. Not FDIC-insured/not bank-guaranteed/may lose value.