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How Higher Interest Rates Impact Investors

How Higher Interest Rates Impact Investors

April 25, 2018

Higher Interest Rates:  Bad News for Investors, Good News for Savers?

The experts have been predicting it ever since the financial crisis.  Higher inflation will result from all the government fiscal stimulus.  Such inflation will force the federal reserve to raise short term interest rates, while bond investors demand higher interest rates to offset its effects.  For the better part of a decade, the experts have been frustrated as interest rates remained persistently low – until this year.   

Higher interest rates and the potential for inflation are the primary force behind the stock market’s return to volatility this year, as well as persistent declines in the bond market.  Interest rates and inflation are both extremely important to investor returns.  

Here are a few reasons interest rates matter so much to stock investors.

  1. Competition for stocks. One of the driving forces for higher stocks in the past couple of years has been the fact that investors had little choice.  Bond yields under 2 percent, and bank CD’s under 1% forced investors seeking any kind of meaningful return into stocks.  As interest rates move higher, some of those investors will leave the market for the (still low, but now improved returns and relative safety of the fixed income markets.
  2. Impact on stock buybacks. Another factor that has driven stocks up has been companies buying back their own stock, often with borrowed money.  Companies would borrow by issuing bonds, then buy their own stock in the market, pushing the price of the shares higher in the process.  As interest rates increase, this becomes more expensive.  
  3. Impact of inflation and higher borrowing costs on profits. Inflation will hurt corporate bottom lines, as labor and material costs increase – but companies find it hard to pass on these costs with higher prices of their own due to competition.  Higher interest on loans and debt also hurt profits.  Record high corporate profit margins have been a third important driver for the stock market over the past two years, and now those profit margins are seen as at risk, leading stock prices lower. 

The silver lining – higher rates are not all bad. 

Not all investors WANT to be in stocks.  Higher yields on fixed income over the long run are appealing to more conservative investors.  It is not the ultimate destination of higher rates that is the problem – we actually WELCOME higher interest rates.  It is only the path from here to there that can be a bit treacherous as the bonds we already own decrease in value. 

We already see the silver lining and are taking advantage of new opportunities in fixed income.  Over the past few months, the interest rates paid on “brokered CDs” – bank CD’s bought and sold on the TD Ameritrade brokerage platform – have spiked dramatically.  We can suddenly buy 1 year CDs at over 2% and 3 year CD’s are pushing close to 3%.  As a result, we are parking some clients short term cash needs (for retirement distributions primarily) in ladders of these fixed income products.  The yields are still low by historical standards – but getting paid a fair price to park funds needed over the short term in a product with guaranteed return of principle is appealing. 

Investing short term cash needs out into guaranteed fixed income matched to the date the money is needed gives investors increased ability to weather the volatile markets with the remainder of their money.  If I know all the funds I need to live on for the next 3 years are nice and safe – I can wait out the markets and tolerate a little more volatility with the rest of my portfolio. 

One caveat to note – the current market value on brokered CD’s may also fluctuate as interest rates change – but investors know – with the certitude of FDIC insurance – that all interest and principle will be paid in full at maturity.  In this way, owning brokered CDs is very similar to owning a US Treasury bill or note. 

Will Rates Keep Going Up? 

The ability of the economy and markets to absorb higher interest rates is likely more limited than it used to be.  Rates can only go up so far before the economy will start to feel the pressure and growth will slow. 

While everyone seems to think rates are destined to move higher, this is not necessarily the case.  Rates WILL move higher as long as the economy is growing close to its capacity and inflation continues to threaten.  A slowdown in economic growth (possibly brought on by higher interest rates) may cause bond prices to rally as investors seek the safety of Treasuries.  Slower growth would also cause the Fed to ease off on its own brakes.  Both of these results would lead to LOWER rates.  So bond investments do continue to offer refuge from falling stock prices brought about by an economic slowdown, and thus are still deserving of a place in a well diversified portfolio, particularly for more conservative investors.

How long does it take before Bond Fund investors start to enjoy the benefits of higher rates? 

Remember your bond funds own bonds (duh).  And when interest rates go up, it means new bonds are paying higher interest.  As old bonds mature, they are being replaced with newer bonds paying higher rates.  This will eventually increase the interest dividend payout of the mutual fund.  The process is continuous, with bonds maturing and being replaced in a large mutual fund on a daily basis.  If the average maturity of the fund is 5 years, then after 5 years, approximately half of the bond holdings will have been reinvested, hopefully at higher rates.  So while it takes some time for the benefits of higher rates to flow through to bond fund investors, there is a benefit in terms of higher income to those with a longer term perspective.  The takeaway:  If you think rates are moving higher, don’t own mutual funds with very long maturities  .