Many individuals and institutions that borrow money have enjoyed a prolonged period of low interest rates. As our economy continues to improve it seems inevitable that interest rates will move higher. It is important to have a basic understanding of how rising interest rates could affect not only your wallet but also your investment portfolio. It's a simple premise that interest rates help control the flow of money in our economy.
As interest rates rise the prices of previously issued bonds tend to decrease. Think of it this way; let's imagine that our local grocery stores sold bonds, and that every bond they sold was at par value or in this example, $1,000 each. If today's interest rate was 3 percent and you purchased a bond for $1,000 you would earn $30 a year on that investment. Next visit to the grocery store you decide to invest another $1,000 but interest rates have moved higher to 4 percent. Your new bond will now pay you $40 a year in interest. The point here is if you can now earn 4 percent on bonds sold at the grocery store, nobody will pay you $1,000 for your first bond that is only yielding 3 percent. So if you wanted to sell the first bond, logically it would sell for less than the new 4 percent bonds.
The lesson here is that as interest rates go up, bonds typically go down, and as interest rates go down, bond prices will typically rise.
Rising interest rates can have a positive or negative impact on the stock market. Rising rates may affect certain industry groups more that others. For instance, growth oriented companies often find it necessary to borrow money in order to expand; rising interest rates increase the cost of their debt, which in turn decreases profit. As a result, their stock prices may fall.
If you feel interest rates are moving higher, consider the following:
Bond investors: Consider owning bonds individually as opposed to bond funds. You can control your portfolio's interest rate risk with careful selection of maturities by paying attention to the yield to maturity.
Stock Investors: Consider stocks of companies with strong balance sheets, low debt to capital ratios, and companies that don't depend on borrowing to operate.
If you are interested in learning more about what rising interest rates mean to you, a financial advisor can help you better understand the effects interest rates may have on your investment portfolio.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. Bonds offer a fixed rate of return and investment principal if held to maturity. In addition to market and interest rate risk, bonds are also subject to default risk, the risk that companies or individuals will be unable to make the required payments on their debt obligations.
William J. Hertzog, CIMA, is first vice president of investments for Wells Fargo Advisors, LLC, in Ahwatukee. Reach him at (602) 952-5133. Wells Fargo Advisors, LLC, member SIPC, is a registered broker-dealer and a separate non-bank affiliate of Wells Fargo & Company. Note: Investment and insurance products are not FDIC insured, not bank guaranteed and may lose value.