Interest rates are often in the news these days, due to their effect on so many people’s lives. In August 2024, the Bank of England dropped interest rates for the first time since the UK entered the COVID-19 lockdown in March 2020.
Interest rates affect:
- Mortgages
- Credit card borrowing
- Savings
- Investments
In this article, we’ll examine the close links between inflation, interest rates and investments.
Interest rates definition
If you borrow money, the interest rate is the fee you will be charged for borrowing that money. If you save money, the interest rate is the amount you are rewarded for saving.
The relationship between investments and interest rates
The relationship between investments and interest rates is inverse. That might sound complex, but all it means is that when interest rates rise, bond prices fall. And vice versa. So, when interest rates increase, it’s more expensive to borrow money.
It’s very important for investors to understand this relationship, as even seemingly small changes in interest rates can significantly affect different types of investments.
How does interest rate affect investments?
How interest rates influence borrowing costs
If interest rates rise, your borrowing becomes more expensive. Whether you’re looking for a mortgage, a credit card offer or a new car, it will cost you more money than the previous interest rate.
The impact on consumer spending and business investment decisions
An interest rate increase has far-reaching effects on everyone, as it reduces disposable income and limits consumer spending.
Businesses and investors pay close attention to consumer spending. If consumers are spending less, businesses and investors are less likely to invest because the return on investment can be uncertain. They are more likely to wait until the economy improves.
How interest rates help determine the attractiveness of various investment options
Interest rates can help determine the attractiveness of various investment options.
- Shares – If there is an interest rate increase, and you have shares, the share prices will go down, because businesses incur more costs. However, remember that wouldn’t necessarily affect your dividend in the long term.
- Bonds – Most bonds pay fixed interest rates. So, when interest rates do go down, this drives up the demand and price of your bond. But if there is an interest rate increase, the price of the bond will decrease, because investors will no longer prefer the lower fixed interest rate.
Understanding investment interest rates
Definition and significance of investment interest rates
Investment interest rates are important in business. So much so, people and companies will base investment decisions on the effect interest rates have on them. See the effect of interest rates and shares and bonds, above, for example.
Companies weigh up the marginal costs and benefits of investment decisions. And good investors only undertake an investment if the marginal benefits outweigh the marginal costs.
- Marginal benefit – expected rate of return on investment
- Marginal costs – the interest rate
Different types of investment interest rates
- Fixed interest investments – investors lend money in return for a fixed rate of interest, or ‘yield’. These include bonds or gilts.
- Variable interest investments – as the name suggests, variable interest means the rate can go up or down without your input.
A variable rate offers greater flexibility for investors and the potential for greater returns than fixed. However, there is more unpredictability.
How investment interest rates are determined in the market
The state of the economy plays a significant role in investment interest rates. Most obviously, for example, the Bank of England’s Base Rate decisions, as we’ve already seen, have a huge impact, even potentially with seemingly slight changes.
If the rate of interest is lowered, this stimulates economic activity, because it encourages borrowing and can make investing more attractive than saving.
If the interest rate is increased, borrowing is discouraged, economic activity falls, and makes saving more attractive than investing.
The link between inflation and interest rates
Inflation is the measure of how much the things we buy have risen over a period of time, so there is an inevitable link between inflation and interest rates.
The relationship between inflation and interest rates
Usually, the relationship between inflation and interest rates is inverse. This means that:
- When interest rates are low, inflation normally rises
- When interest rates are high, inflation normally falls
How inflation expectations can influence investment decisions
With the theory above in mind, investors should try to buy investment products with financial returns that are equal to, or greater than inflation.
For example, if stocks returned 4% and inflation was at 5%, then the real return on investment would be minus 1%.
The impact of rising interest rates on inflation and investment strategies
You definitely need to take inflation into account in your investment strategy. As inflation reduces real returns on financial investments and lessens your purchasing power. Which means your investments may be worth less when you really need to use them.
Diversification in investment portfolios
Diversification is a time-tested strategy for managing risk and optimising returns, especially during periods of fluctuating interest rates. By spreading your investments across various asset classes and sectors, you can reduce the potential impact of interest rate changes on your portfolio. Let’s explore the benefits, strategies, and the critical role of financial planning in maintaining diversification.
The Benefits of Diversification
Risk Mitigation: Interest rate changes affect asset classes differently. For example, rising interest rates may decrease bond prices but can increase the attractiveness of savings accounts or certain fixed-income investments like certificates of deposits (CDs). Real estate investments may provide consistent income, even when stock prices are volatile.
Smoother Returns: A diverse investment portfolio balances high-risk, high-reward assets such as stocks with more stable options like bonds or fixed deposits. This balance ensures your overall risk remains manageable while aiming for steady returns.
Adaptability to Financial Goals: Diversification allows your portfolio to be customised based on your time horizon, risk tolerance, and financial goals.
Want to create a balanced portfolio? Read more about Types of Investment Strategies.
Strategies for Constructing a Diversified Portfolio
Balancing Stocks and Bonds: A mix of equities and fixed-income assets can create resilience:
- Equities (stocks) offer higher growth potential but are sensitive to market rate changes.
- Bonds provide stability, particularly those with shorter maturities, which are less affected by rising interest rates.
Exploring Multiple Asset Classes: Go beyond traditional investments by including:
- Real estate income properties, which offer consistent returns even during interest rate hikes.
- Alternative investments, like commodities or hedge funds, to achieve risk-adjusted returns.
- Savings accounts or CDs for liquidity and security.
Regular Portfolio Reviews: Adjust your portfolio as interest rates, inflation, and personal circumstances evolve. Consulting with a financial advisor ensures your diversification strategy remains effective.
To learn more about the relationship between inflation and investments, explore How Does Inflation Affect Investments.
The Role of Financial Planning in Diversification
A diversified portfolio doesn’t happen by accident, it requires careful financial planning. A professional financial planner can:
- Assess your risk tolerance and create an asset allocation that aligns with your financial goals.
- Provide insights on how to manage your portfolio during periods of fluctuating interest rates.
- Monitor economic trends and adjust your strategy to ensure stability and growth over time.
Diversification, paired with expert planning, helps you stay resilient against market fluctuations and achieve your financial goals.
Interest Rate Impact on Bonds and Stocks
Fluctuating interest rates have a direct and often complex effect on bonds and stocks. Understanding these dynamics is essential for making informed investment decisions.
Interest Rate Impact on Bonds
Bond Maturities:
- Shorter Maturities: These bonds are less sensitive to rising interest rates, making them more stable options during periods of rate increases.
- Longer Maturities: These bonds experience greater price fluctuations, leading to potential paper losses when interest rates rise.
Bond Yields: When interest rates increase, bond prices fall, leading to higher bond yields. Conversely, falling interest rates reduce bond yields but drive up bond prices.
Interest Rate Impact on Stocks
- Stock Prices: Rising interest rates increase borrowing costs for companies, which can reduce profit margins and lower stock prices.
- Future Earnings: Higher rates often reduce the present value of future earnings, making stocks less attractive.
- Broader Market Impact: Rising interest rates can shift investor preferences toward safer options like savings accounts or bonds, reducing demand for stocks.
Beyond Bonds and Stocks
- Real Estate Income: Higher interest rates can increase borrowing costs for property investors but may also drive demand for rental income properties.
- Market Value Across Assets: A diversified portfolio that includes assets like commodities or alternative investments can provide stability when traditional asset classes are affected by rate changes.
Role in Economic Policy and Inflation
Interest rates are a cornerstone of economic policy, directly influencing inflation, employment, and consumer spending.
Inflation Control through Interest Rates
Central banks, like the Bank of England, adjust interest rates to meet inflation targets. When inflation rises, interest rates are often increased to reduce spending and borrowing. Conversely, lower rates stimulate economic activity when inflation is low.
Broader Economic Impacts
- Cost of Borrowing: Higher interest rates increase borrowing costs, reducing consumer spending and corporate investment.
- Economic Growth: Interest rate adjustments can either stimulate or cool down the economy, affecting job creation and overall growth.
- Savings Behaviour: Rising interest rates encourage savings, offering better returns on deposits and fixed-income investments.
To understand inflation’s impact on investments, check out How Does Inflation Affect Investments.
Conclusion
As you can see, if you’re an investor, it’s vitally important to monitor interest rates so you can make informed decisions. Never forget that investments can go up as well as down.
Now you’ve learnt how interest rate can affect investments, if you need help with your investment management & decisions, get in touch today to speak with one of our industry leading, highly qualified investment advisors.
