Interest rates, or the price of borrowing money, have fluctuated greatly over time. In the early 1980s in Canada, interest rates were north of 20%. Although interest rates have been rising recently, we are still fairly close to all-time lows in rates globally.
Interest rates impact different investment asset classes in various ways. High-interest rates make investing in bonds or putting money in fixed income more attractive.
On the other hand, low interest rates make fixed income less attractive and encourage investing in stocks. As interest rates increase or decrease, they will impact investments in different ways as well.
Investing can be thought of in a simple way. A person with excess capital is providing funding to an individual that needs it, in exchange for a rate of return.
The level of interest rates can dictate how attractive it is to keep your money in a deposit account at the bank.
We’ll cover how interest rates affect your investments below.
A High-Interest Rate and its Impact
A high-interest rate is not something that is generally desirable by most stakeholders within an economy.
A higher interest rate makes it more attractive to keep your money in a deposit account at your local bank, earning interest. Since more money is sitting in a bank account earning interest, it is not being spent or invested. This tends to have a negative impact on the economy.
A high-interest rate also makes investing in bonds and other fixed-term deposits more attractive.
According to textbook economic theory, central banks are doing a good job if interest rates are at their highest when an economy is at its strongest.
When do Interest Rates Begin to Rise?
Interest rates usually begin to rise in response to two main causes. These causes are a high inflation rate and an overheating economy.
When inflation within a country is high it creates extreme instability for businesses. Costs of inputs are rising rapidly and the purchasing power of cash is decreasing.
In order to fight inflation, central banks can raise interest rates. This helps to curb inflation by reducing money velocity.
If inflation is not a concern, interest rates can also be raised when an economy is at maximum capacity and overheating. In theory, central banks should raise interest rates when economic times are great so that they can be lowered during difficult times.
How do Rising Interest Rates Affect Investments?
During the process of rising interest rates, or a hiking cycle, asset classes are significantly impacted.
Bonds fall in price as interest rates rise because of the inverse relationship between rates and bond prices. This impact is greater the further out the maturity of the bond is.
As interest rates are rising, stocks become relatively less attractive to begin investing in.
Variable-rate bonds and loans tend to perform well as interest rates are rising. Financial institutions also have an easier time earning a profit as rates are rising.
Investment ideas that generally perform well during rising interest rates include:
- Floating-rate bonds or bond funds that pay more as rates rise
- Variable-rate private debt that also pays more with increasing rates
- Targeting the financial sector for relative outperformance
A Low Interest Rate and its Impact
A low-interest rate is something that is generally beneficial to an economy.
Savers are paid little to keep money parked in a savings account and investment or consumption is encouraged. Money tends to flow into things such as stocks and alternative investments like private equity.
Textbook economic theory again indicates that interest rates should be at a low when the economy is at its worst.
One of the main problems in today’s global economic environment is that we have become too accustomed to low interest rates. Japan actually embraced negative interest rates in 2016 to encourage borrowing and spending in order to fight deflation.
When do Interest Rates Begin to Drop?
There are two typical scenarios in which interest rates begin to drop. These are when an economy enters a recession or if there is deflation is running high.
A high rate of deflation is viewed by economists as being even more dangerous to an economy than a high rate of inflation.
Since the purchasing power of money is increasing over time, people will want to hold cash and avoid investing or lending money. Dropping interest rates can combat deflation by encouraging spending and lending.
As an economy is experiencing a recession or downturn, central banks should begin or be in the process of lowering interest rates. As interest rates are falling and capital is encouraged to flow, this helps to counter economic weakness.
How do Dropping Interest Rates Affect Investments
During the process of falling interest rates, different asset classes are again significantly affected.
Bonds increase in price as interest rates fall because of the inverse relationship between rates and bond prices. This impact is again greater the further out the maturity of the bond is.
As interest rates are falling, stocks become an increasingly more attractive investment. This is especially true for dividend-paying stocks which could potentially replace low-yielding fixed income for investors that require steady cash flows.
Variable-rate bonds and loans tend to underperform when interest rates are falling. Financial institutions also have a harder time earning a profit as interest rates are low and falling.
Investment ideas that generally perform well during dropping interest rates include:
- High-duration government bonds or debt
- Dividend-paying stocks
- Quality stocks that have experienced a significant sell-off due to a market correction (which would coincide with falling rates)
Investments that are Not Affected by Interest Rates
Some rare asset classes exist which are not affected by changes in interest rates, or underlying economic conditions.
These funds or strategies are typically referred to as being market-neutral. In almost all cases, these strategies are either hedge funds or liquid alternatives.
Market-neutral strategies depend entirely on the skills of their portfolio manager to generate returns. These returns are usually obtained through long-short pair trades, which eliminate a large portion of the market’s impact on returns.
Since many market-neutral strategies have different approaches and risk exposures, always do deep due diligence on any fund or strategy before adding it to your portfolio.
Interest rates, or the price of money over time, have an enormous impact on the overall economy as well as different investment asset classes.
Rising rates negatively impact bond prices the most while taking away the flow of capital from stocks, and vice versa.
When interest rates are low, bonds are less attractive while stocks, especially those paying dividends, are usually in high demand.
The opposite is true in an environment with high interest rates. In the current rising interest rate environment, floating rate funds may be something to consider for your portfolio.