I had to get a knot out of a drawstring bag the other day.
Funny- when you start to pull the knot apart, you may be surprised at how the strings are intertwined. This is an analogy for the relationship between higher interest rate and your stock portfolio. The connection may surprise you.
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In mid-December of ’16, you probably noticed lots of stories about interest rates increasing. Your first thought may be that the interest rate you pay on a home mortgage or car loan will be higher, and that’s true. Higher interest rates also impact your investments, and all investors need to understand how their portfolios are affected.
What triggers an interest rate increase
The Federal Reserve recently increased the target federal funds rate by a quarter of a percentage point. The federal (fed) funds rate is the interest rate that financial institutions use to lend to each other. If Bank A, for example, lends funds to Bank B, the federal funds rate would be used as the interest rate on the loan.
When banks lend to consumers, the home mortgage or car loan is based on the fed funds rate. If Bank B pays a 1% fed funds rate to borrow from Bank A, the interest rate Bank B charges on consumer loans will be greater than 1%.
Higher interest rates, higher earnings on bonds
As interest rates increase, borrowers have to pay more in interest to secure loans, and that includes bond issuers. Assume, for example, that IBM wants to issue a 20-year corporate bond. When the Fed increases interest rates, IBM will need to pay more interest to compete with other bond issuers in the marketplace.
The flip side is that bond investors can earn more interest on bonds as interest rates rise.
If you work with a financial advisor or you’ve invested in your 401(k) retirement plan at work, you’ve probably considered your portfolio’s asset mix. Your total assets (dollars invested) are assigned to asset classes: stocks, bonds, cash and other investments.
As interest rates rise and the potential interest earned on bonds increases, investing in bonds becomes more attractive. You may consider changing your asset mix by shifting more dollars into bonds and less into stocks. Of course, your asset mix decision should also consider your number of years to retirement and the level of risk you’re comfortable with.
The rate of return you should consider is total return, and that term has a different meaning for stocks vs. bonds:
- Stocks: Total return for a stock is any dividends earned for the year, plus any increase in the stock’s price. A decline in the stock’s price reduces the total return.
- Bonds: A bond’s total return takes is the interest income earned on the bond plus any increase in the bond’s price. A decline in bond prices reduces the total return.
Here’s a chart that displays the annual total returns for stocks in the Standard and Poor’s 500 index since 1988. This index tracks 500 of the largest stocks traded, based on their market capitalization. As you can see, the S&P 500 annual returns can vary widely from year to year, but the average annual return for the index over the last 70-80 years is about 10%.
Assume that your asset mix is 70% stocks and 30% bonds, and you’re operating on the assumption that your long-term total return on stocks will be 10%. Let’s say that the interest rate you can earn on a 20-year corporate bond increases from 6% to 8%. That 8% is attractive, because you can buy a bond, hold it until maturity, and earn 8%.
Bonds offer more certainty. As available rates on bonds increase, you may be able to earn a rate close to the expected 10% rate on stocks- and not be exposed to stock price fluctuations.
As interest rates move up, consider how higher rates on bonds may impact your asset mix. This information is for educational purposes only. As always, consult with a financial service professional and a CPA for specifics.
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
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Terrapin Flyer, Wall Street (CC BY-SA 2.0)