Interest rates undeniably play a crucial role in the world of investment and most of investors might have experienced it personally.. Any change in interest rates can affect the market, changing valuations, changing returns, and altering investor perception. May be you are a novice investor or experienced investor it doesn’t matter. Having a solid knowledge about how rising interest rates effect your portfolio is a must. If you know how interest rate increases effect the different types of assets, you can make better decisions and guard your portfolio against unexpected surprises.
Generally Federal Reserve raise interest rates usually to manage inflation and keep the economy from becoming overheated. Although this may be beneficial for the economy in the long term however, it frequently results in volatility in bond and stock markets.
Effects of Rising Interest Rates on Different Assets :
Inflationary pressures aren’t the same for all assets. Here’s a quick summary of how various sectors and asset classes generally react:
Bonds : Relation between Interest rate & bond price is quite interesting. As the interest rates rise, bonds that have lower yields become less appealing which causes their market value to decrease. To be more precise Long-term bonds are more vulnerable than shorter-term ones. This is the reason why many investors move towards shorter-duration bonds or floating rate debt during rate hiking times.
Stocks : Growth Stocks are particularly vulnerable to the rise in interest rates. These companies often depend on the future of earnings to determine their valuation. When interest rates rise, the company’s future earnings will be discounted higher which causes share prices to drop. In case of “value stocks” the scenario is a little bit positive. Even the Value stocks undergo price correction during Interest rate hike cycles, but because of the strong cash flows , these companies share price dips by small percentage when compared to growth stocks. Even if the price dip is more than expected, these value stocks are the first to bounce back once the market settles down.
Real Estate : Rising interest rates could result in expensive mortgage rates which directly have negative impact on the demand for housing. Similarly the demand for investment properties also comes down because of the rise in interest rate.
Real Estate Investment Trusts (REITs) are heavily dependent on debt, so they also become the victims of this rate hike. Yet, some segments of real estate might still perform very well especially those that are tied to essential services.
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Investment Strategies to implement during Rising Interest rate Cycle :
Shift Towards Value Stocks :
If interest rates begin to increase and investors start to be nervous, especially those who are heavily invested in Growth Stocks. Although these stocks can provide incredible returns in times of boom. However these stocks make a huge dent to your overall portfolio in the scenario where borrowing costs increase.
How smart investors handle such situations ? How they are going secure their portfolio from such unexpected events ?
Answer is very simple and it is a proven method. Generally Smart investors in this kind situations they shift focus from growth to value stocks. As value stocks are more resilient , they can as a shield in protecting your portfolio.
Value stocks usually provide more stability during the times of market volatility. Generally these companies have solid balance sheets and steady income streams. These companies are already profitable so they don’t risk of attaining massive growth in the next 5 or 10 or 15 years.
Value stocks are typically seen in banking sector, insurance, Energy etc.
Invest in High Quality, Dividend-Paying Stocks:
Invest generally fear about their investments in advent of events like “Interest Rate Hike”. Stock prices of companies dips by huge value and if your investment is more into “growth stocks”, then your investment value would be even more low.
In such situations dividend-paying stocks can be you savior. You will come to know about importance of holding dividend paying stocks in your account. They provide a steady flow of cash regardless of the share price fluctuation.
Companies that pay dividends regularly are typically backed by solid financials and well-planned business strategies. Another interesting thing is dividend stocks offer peace of mind even during the touch times. So having Dividend stocks in your portfolio can boost up your emotional decisions and you can stick to your long term investment goals.
Diversify Your Investment Across Asset Classes
One of the most effective ways to protect your portfolio from rising interest rates is through diversification. As per the popular saying “don’t put all your eggs in one basket”, spread your investments across different asset classes such as equities, bonds, commodities like gold & silver etc.
Once the hike about interest rate news comes out all types of assets will get affected. But all these assets wont react in the in the same way.
Have you heard the term “Global diversification” ? It is an wise option investors choose during uncertainty in the market. Different regions and countries increase or decrease interest rates according to their economic circumstances. So it would be a wise decision if you diversify your portfolio on global level.
Investing a small percentage of your funds in international bonds or equities can help to cushion your portfolio and provide you access to growth opportunities outside of your home market.
Increase your investment in Inflation Protected Assets :
As we all know Inflation and interest rates are interrelated, so it would a smart move to increase your exposure to the inflation protected assets. TIPS (Treasury Inflation Protected Securities) is one such investment instrument , which is safe even during “Interest hike” period. TIPS are government bonds specifically designed to protect against inflation. We will cover more about TIPS in our upcoming articles.
Another investment option which can act as hedge during inflation are commodities and real estate. Commodities like Gold, Oil , Silver etc. tend to appreciate during times of high inflation, so you can use them as hedging tool for your portfolio.
Keep Cash and wait for the Opportunity
Large investors hold cash in their accounts and look for opportunities in the market. Such opportunities only arise when there is uncertainty like hike in interest rates etc. Cash help to protect your capital and provide the ability to breathe when markets are unstable. Contrary to stocks or bonds the value of cash isn’t diminished when interest rates increase.
Summary: Hope we have covered all the investment strategies which act as fool proof especially during the uncertainties like rise in interest rates. Any suggestions, please do let us know in the comments section.
