Interest rates are often overlooked by investors until they begin to rise. The federal funds rate—the rate to which the prime rate is tied—reached a historic low of 0.05% as the pandemic took hold in April 2020. Since then, it's been a flat .09% as of December 2020. The prime rate is the rate banks charge their customers most trusted with credit and is the basis for all other rates.
The federal funds rate is adjusted by the Federal Reserve (the Fed) as part of their monetary policy authority, giving them the ability to attempt to control runaway economic episodes.
When interest rates rise, it's typically a reflection of a booming economy. The Fed raises interest rates to keep the economy from growing too rapidly or triggering a rise in the consumer price index. Interest rates can also be reduced in attempts to keep the economy from shrinking or continuing to fall. Rate hikes or decreases are usually spread out over a period of months or years to keep pace with economic expansion.
- Interest rate fluctuations affect bond prices inversely, with prices increasing as rates go down and decreasing as rates go up.
- Stocks are not directly affected by rising rates, but investors tend to chase better returns by moving to stocks when rates go up.
- A diversified portfolio of stocks, bonds, cash, and cash equivalents is better for maintaining growth than trying to time the market for the best prices and rates.
The Effect of Rates on Investments
Rates affect investor's bond portfolios—increasing rates lower bond prices while decreasing rates have the opposite effect. Rate fluctuations have not been correlated to stock prices, but they do cause the stock market to fluctuate. Investors should be familiar with the effects of rates on their portfolios so that they can create strategies that decrease the risk of their investments.
For investors, rising rates can have significant portfolio implications, specifically for income investors who favor bonds. Bonds and interest rates have an inverse relationship; when rates rise for an extended period, bond prices decrease. Rising rates can directly impact bond yields; long-term bonds with maturity terms ranging from 10 to 30 years see more substantial effects. Short-term bonds may be less affected by rising rates.
Understanding how to manage your portfolio when rates are rising can help to mitigate any potential negative effects. The chart below shows the price-yield relation for a 10-year, 9% annual coupon bond.
What to Do When Interest Rates Go Up
Big rate gyrations, in both the short- and long-term, can significantly impact the balance in your portfolio. And, as in tightrope walking, balance is critical to success in investing.
The first step is understanding the composition of your portfolio and the way individual asset classes are likely to be impacted by rising rates. A typical diverse portfolio is likely to include stocks, bonds, cash investments, equivalents, and real estate.
Generally speaking, rising rates do not have a direct correlation to stock prices. However, rising rates can still have an impact on stocks because higher rates affect consumers' ability to borrow and pay off debt. Loans and credit cards become more expensive as rates rise; when consumers carry higher debt levels, it can affect the amount of disposable income they have to spend on consumer goods.
When consumers spend less, it directly impacts corporate net profits. Shrinking revenues or reduced profit growth can, in turn, affect a company stock's performance.
Certain stock sectors can, however, benefit from rising rates as they suggest stronger economic growth. Cyclical industries such as financial institutions, industrial companies, and energy providers tend to perform better when rates rise.
The real estate investment trusts, utilities, consumer staples, and telecommunication (RUST) sector is the one that investors must keep a close eye on when rates begin to climb. Real estate, in particular, is an asset class to watch, as rising rates can push home-buying out of reach for certain borrowers. At the same time, rising rates can be a boon for rental property owners, who may be able to charge higher rent prices if rental demand remains high.
The Impact on Bonds
Bonds are more likely to see a more immediate negative impact associated with rising rates. But, it's important to keep the effects of rising rates on bonds in perspective. Stocks, by comparison, have the potential to be much more volatile than bonds. When a sustained bull market (prices continuing to rise) begins to look bearish (prices continuing to fall), bonds can offer consistent income and dampen portfolio volatility over the long term.
In periods of uncertainty, such as the economic transition following an election or the passage of new tax laws or tariffs, bonds can be more appealing to investors concerned about the possibility of a market correction (a 10% to 20% drop in stock prices).
If you have cash holdings in your portfolio, such as certificates of deposit, liquid savings accounts, or money market instruments, rising rates mean a higher return on your investment. As rates climb, banks tend to offer correspondingly higher rates on deposit accounts. Of course, the returns on these investments are typically much lower than the returns associated with stocks or mutual funds, but you're not assuming the same degree of risk as you would with a stock.
A Final Takeaway
The answer to how you should be investing when interest rates rise is fairly simple: you should invest the same way you should always be investing. That means building a diversified portfolio made up of quality stocks, bonds, cash, and cash equivalents that will pay dividends through the ups and downs of the markets and the global economy at large.
Trying to time the market or predict which way rates will go is a wasted effort; the smartest thing investors can do is mindfully manage their portfolios to limit the downside and increase potential upside as interest rates and the market fluctuate. Diversification is the best way to do that—regardless of where rates are headed for the short- or long-term.
The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.