Earlier this month, the Federal Reserve (Fed) announced that it would begin taking steps to raise interest rates and end its quantitative easing policy to halt rising inflation. With inflation currently hovering around 7.00%, businesses and consumers are feeling the pinch of rising prices. The Fed’s actions aim to reduce the inflation rate to a more comfortable level of 2.00% to 3.00%. To do this, the Fed will raise its federal funds rate. The federal funds rate is the rate at which banks can borrow and lend to each other so they can continue to lend to businesses and individuals. They will also end their quantitative easing policy. Quantitative easing is a monetary policy that allows the central bank to buy long-term securities on the open market. The policy increases the amount of money in the money supply, encourages lending and investment, and lowers interest rates. By raising interest rates and ending quantitative easing, the Fed hopes to reduce the amount of money in the money supply and bring inflation rates down to more comfortable levels.
What could be the impact of a rise in interest rates on your investments? Bond prices generally move in the opposite direction to interest rates, which means that rising interest rates usually cause the prices of previously issued bonds to fall. This is commonly referred to as interest rate risk. When the yield of newly issued bonds is higher than the yield of older bonds, the newly issued bonds are more valuable. If you own an older bond, you need to sell that bond at a discount to get someone to buy it, otherwise they would just buy a new bond. Thus, the value of old bonds decreases when interest rates rise. Additionally, with higher yields available with new bonds, many investors tend to sell their current bonds to buy the highest yielding ones. The massive sales drive the prices of old bonds even further down.
The best way to manage interest rate risk is to have a diversified portfolio, including international and domestic bonds with short to intermediate maturities, as they may be less affected by rate increases. The sooner a bond matures, the sooner you can use the proceeds to buy bonds with higher coupons. The trade-off is that bonds with shorter maturities tend to pay lower coupons than longer-term bonds. A combination of short-term, mid-term, and high-yield bonds is worth considering. Each offers value in different ways, so not all of your bond holdings will be equally exposed to rising interest rates.
If you don’t want to have to buy and sell your own bonds, bond mutual funds and exchange-traded funds (ETFs) are good options. Fund managers are constantly replacing maturing bonds with newly issued bonds in order to adapt their portfolio to changing rates. This can often reduce the negative impact of rising interest rates on the value of your bond holdings.
Although less predictable, stocks also tend to move negatively when the Fed raises interest rates. The reason for this is that businesses, including large corporations, now have to borrow money at a higher rate. This means that more money has to be allocated to repay the loan(s), so profits tend to decrease. Moreover, consumers are also borrowing at higher rates. So they, too, have to devote more money to repaying their loans and have less discretionary income to spend. Less expenses means less revenue and profits for businesses.
If companies are seen as reducing growth due to less borrowing or are less profitable due to higher debt loads or lower revenues, their stock prices will often fall. If many companies experience these declines, the overall market, or key indexes such as the S&P 500, Dow Jones Industrial Average, Nasdaq and Russell 2000, will fall.
As with bonds, the best way to manage interest rate risk is to be diversified. The Fed interest rate hike is primarily a US-focused event. Although other countries could follow suit, it is unlikely to be matched globally. Therefore, holding a mix of US-based stocks, mutual funds and ETFs, as well as international and emerging market holdings, is the best way to reduce the impact of rising rates. on your stock positions.
What is the overall takeaway? Diversification is the key. The more diversified your stock and bond portfolio is, the less likely you are to be affected by rising interest rates. Going further, the more diversified you are, the less likely you are to be affected by any event that negatively affects a specific type of investment.
The material has been prepared or distributed for informational purposes only and does not constitute a solicitation or offer to buy any securities or instruments or to participate in any trading strategy. Investing involves risk, including risk of loss. Before investing, you should consider the investment objectives, risks, charges and expenses associated with investment products. Investment decisions should be based on an individual’s own goals, time horizon and risk tolerance. Past performance is not indicative of future results. Diversification and asset allocation do not ensure profit or guarantee against loss. Consult your financial professional before making investments.