Even if you didn't take Economics 101 in college, just navigating through the past several years has given you hands-on experience with one of the course's most valuable lessons: The rise and fall of interest rates is one of the biggest factors influencing global economies, 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 as the cost to finance a purchase is relatively inexpensive. 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. Once the higher interest paying bonds are called, investors looking for a fixed rate of return are faced with lower yielding fixed-income alternatives. To offset this risk, it’s important to have a diverse portfolio of fixed-income investments with a variety of maturities and call features to withstand fluctuations in rates.
For stock investors: Falling interest rates tend to have a positive impact on the stock market, especially stocks of growth companies. Companies that tend to borrow money to finance expansions tend to benefit from declining rates. Paying lower rates of interest decreases the cost of the debt, which may positively affect a company's 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. Changes in interest rates tend to affect the economy slowly – it can take as long as 12 to 18 months for the effects of the change to permeate the entire economy. Slowly, as 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 as the expense of financing a purchase increases. This reverses the effects that lower interest rates had on the economy and, again, investors are affected differently.
For bond investors: In a rising interest rate scenario, the demand for bonds with lower interest rates declines. New bond issues are offered at higher, more appealing rates, driving the price of existing bonds lower.
For stock investors: 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 may respond favorably. In addition, rising interest rates may affect certain industry groups more than others. For instance, growth companies often find it necessary to borrow money in order to expand. Rising interest rates increase the cost of their debt, which in turn decreases profit. As a result, the prices of their stocks may fall.
Wells Fargo Advisors has a number of tools and resources to help you gain a better understanding of how interest rates can affect your portfolio. Talk to your financial adviser to learn more about what changing interest rates mean for you and your financial situation.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. Bonds offer a fixed rate of return and investment principal if held to maturity. In addition to market and interest rate risk, bonds are also subject to default risk, the risk that companies or individuals will be unable to make the required payments on their debt obligations.
This article was written by Wells Fargo Advisors and provided courtesy of Jonathan Buoni, financial adviser, in Springfield, Mass., at 413-755-1171.
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