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When you invest in the markets, many forces can influence your portfolio and your investment, but very few have a greater impact than interest rates and the position of the 10 year Treasury Department.
An interest rate is simply the amount a lender charges a borrower for borrowing funds, often referred to as an annual percentage, or APR.
This stock market has seen some of its fear over the past year and yet managed to stay stable across the board. A new but very familiar fear has emerged that is making investors question whether stocks are still the place to be in this economy.
During such economic times, the Treasury Department and the Federal Reserve are the two main actors responsible for stabilizing the US economy and returning the country to green pastures and sunny skies.
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The two main goals for these government agencies are price stability, which combats inflation, and full employment, which is focused on lowering the unemployment rate in the US
As interest rates rise, the public can see the impact of this move in changes in mortgage rates when trying to buy a home or increasing the APR on financial institution loans, but that’s just the tip of the iceberg.
Meanwhile, as interest rates rise, money becomes expensive. This means that it becomes more difficult to raise, borrow, or lend capital. This creates a greater barrier for companies to grow, expand, invest, hit projections and also stop.
A company’s balance sheet and profitability are affected by whatever changes the value of that business or an investor’s willingness to pay for that company’s stock. Ultimately, when demand for that stock drops and people start selling their shares, this company’s stock price will go down.
This increases the risk for investors and their portfolio as certain industries and sectors perform better in an environment of increasing interest while others do not.
For example, banks and financial institutions tend to do better because higher interest rates allow for higher margins and higher profits on loans and financial transactions. The opposite is true for real estate or home construction companies, since as the interest rate rises, people are less likely to borrow at the rate at which they previously borrowed.
As interest rates continue to rise and the business cycle reaches its next phase, bonds are becoming increasingly attractive to investors. This can completely change the dynamics of the financial portfolio and the risk tolerance of an investor.
Bonds and interest rates are inversely related. When interest rates rise, current bond prices in the market will fall, which would allow an investor to buy bonds at a “discount”. Newly issued bonds pay investors higher returns as their coupons are higher due to the recent rate hikes.
This dynamic is beginning to change where and how investors and companies put their money as the main theme in investing is risk versus return. In other words, how much risk are you taking to get the return you are getting? Put simply, if you invested $ 50 to make $ 25, it was a better investment than $ 100 to make the same $ 25.
Now you can see how a rising interest rate environment can affect your portfolio and the economy. Within a portfolio, investors have a choice of different stocks, bonds, asset classes and sectors to increase diversification and reduce risk within that portfolio.
Here are some portfolio movements that are typically taken into account during times of rising interest rates:
- Look at more value stocks than pure growth stocks.
- Reduce the long-term bond allocation in the current portfolio.
- Consider adding a bond or certificate for the warehouse manager strategy.
- Reduce holdings of gold, oil, or metals that are typically in a portfolio to protect against inflation.
– By Jordan Awoye, Managing Partner at Awoye Capital