As an investor, it’s important to know whether interest rates are rising or falling. Why? Changes in interest rates impact the performance of stocks and bonds. Which way rates are headed, along with your goals and risk tolerance, may influence how you diversify your portfolio.
Let’s take a look at how rising interest rates may impact your investments and strategies to help sustain your portfolio in this type of economic climate.
The Bond See-Saw
Generally, bond prices and interest rates move in opposite directions—when interest rates rise, bond prices tend to decline. Think of it this way. All other things being equal, given the choice of a $1,000 bond that pays 2% interest or one that pays 3%, which would you choose? The higher interest rate can make the lower-yielding bond less appealing to investors, which causes the price to drop.
Not all bonds react the same way to interest rate changes. Some are more sensitive depending on the type of bond and its maturity. Corporate bonds typically have higher coupon (interest) rates, which generally make them less sensitive than U.S. Treasuries. Bonds with shorter durations (maturities) are usually less affected by rate changes as well.
One way to potentially help minimize the risks of rising interest rates is to create a bond ladder, which involves having multiple bonds with different maturity dates. As the bonds mature, you can purchase new ones with higher yields, assuming rates are still rising. You may also want to consider diversified bond mutual funds or exchange-traded funds (ETFs).
The Ripple Effect on Stocks
Stock prices and interest rates also tend to move in opposite directions, but for different reasons. Higher interest rates make it more expensive to borrow money. A business that doesn’t want to pay the higher cost for a loan may delay or scale back projects. This in turn may slow the company’s growth and affect its earnings. A business’s stock price generally drops when earnings decline. Rising rates typically also lead to a stronger dollar, which may put additional pressure on the stock prices of multinational companies because it becomes more expensive to do business in some countries.
Like bonds, not all stocks react the same way to rate hikes. In fact, some sectors historically perform well during periods of rising interest rates. For example, banks typically have stronger earnings because they can charge more for their services. Of course, past performance is not an indicator of future results.
As you review your portfolio, check to see which sectors your stocks are in. It could be a good idea to avoid being heavily invested in one particular area of the market. You may also want to consider dividend-paying stocks, which historically have performed well when rates rise, diversified stock mutual funds, or ETFs.
Do It for Me Option
Not everyone has the time, desire, or resources to monitor interest rates and actively manage their investments. If this sounds familiar, you may want to consider a managed portfolio. With portfolio management, professional money managers recommend a mix of investments based on your goals and risk tolerance and monitor your account on an ongoing basis.
A Portfolio for All Seasons
Financial markets and interest rates move in cycles, and no one knows for certain how long an upward or downward trend may last. A well-diversified portfolio may help you pursue your financial goals whatever the economic climate.
Hands-On Goal Planning
Evaluate your financial situation and continue to pursue your goals.
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