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When investing in the markets, many forces can affect your portfolio and how you invest, but very few of them have a bigger impact than interest rates and where the 10-year Treasury stands.
An interest rate is simply the amount charged by a lender to a borrower for lending money, which is often referred to as annual percentage rate, or APR.
This stock market has experienced its share of scares over the last year and still managed to stay resilient through it all. A new but very familiar fear has started emerging that have investors questioning if equities are still the right place in this economy.
During economic times such as this, the Treasury Department and the Federal Reserve are the two main players responsible for stabilizing the U.S. economy and bringing the country back to green pastures and sunny skies.
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The two main goals for these government entities are price stability, which tackles inflation, and full employment, which focuses on decreasing the unemployment rate in the U.S.
When interest rates increase, the public may see the effects of this move by changes in mortgage rates when they are trying to buy a home or increased APR on credit credits from financial institutions, but that’s just the tip of the iceberg.
Meanwhile, as interest rates increase, money becomes expensive. Which means that it becomes harder to raise, borrow or lend capital. This creates a bigger hurdle for businesses to grow, expand, invest, hit projections and also to hire.
A company’s balance sheet and profitability are effected as a result, changing how much that business is worth or what an investor is willing to pay for that company’s stock. Ultimately, that company’s stock price drops as the demand for that stock decreases and people begin to sell out of their stock.
This adds another risk to investors and their portfolio because certain industries and sectors perform better in a rising interest environment, while others do not.
For example, banks and financial institutions usually do better because higher interest rates allows for bigger margins and more profits on loans and financial transactions. The opposite is true for real estate or home construction companies because, as interest rate increase, people are less likely to borrow money at the same pace they were borrowing money before.
As rates continue to move upward and the economic cycle hits its next phase, bonds start to become a lot more appealing to investors. This can totally change the dynamics of an investor’s financial portfolio and risk tolerance.
Bonds and interest rates have an inverse relationship. When interest rates increase, the current bond prices in the marketplace will drop, which would allows an investor to buy bonds at a “discount.” Newer issued bonds will pay out a higher income to investors, because their coupons are higher as a result of recent interest hikes.
These dynamics start to shift where and how investors and businesses put their money because the main overwhelming theme within investing is risk versus return. In other words, how much risk are you taking to make the return you are making? Put simply, if you invested $50 to make $25, that was a better investment than investing $100 to make that same $25.
Now you can see how a rising interest environment can affect your portfolio and the economy. Within a portfolio, investors will have an assortment of different stocks, bonds, asset classes and sectors, to add diversification and inherently lower risk within that portfolio.
Here are some portfolio moves that people usually take into consideration during a period of rising interest rates:
- Look more into value stocks as opposed to pure growth stocks.
- Reduce long-term bonds allocation in current portfolio.
- Consider adding a bond or certificate of deposit laddering strategy.
- Cut down on gold, oil or metals holdings, which are usually in a portfolio to protect against inflation.
— By Jordan Awoye, managing partner at Awoye Capital