Interest Rates: What's the Connection to Your Portfolio?
When it comes to interest rates, one thing's for certain: What goes down will eventually come up.
The federal funds rate -- the rate on which short-term interest rates are based -- has varied significantly over time. It's a cycle of ups and downs that can affect your personal finances -- your credit card rates, for example. But what about less familiar effects, like those that interest rate changes can have on your investments? Understanding the relationship between bonds, stocks, and interest rates could help you better cope with inevitable changes in our economy and your portfolio.
Bond Market Mechanics
Interest rates often fall in a weak economy and rise as it strengthens. As the economy gathers steam, companies experience higher costs (wages and materials) and they usually borrow money to grow. That's where bond yields and prices enter the equation.
What is yield? It's a measure of a bond's return based on the price the investor paid for it and the interest the bond will pay. Falling interest rates usually result in declining yields. As rates spiral downward, businesses and governments "call" or redeem the existing bonds they've issued that carry higher interest rates, replacing them with new, lower-yielding bonds. Why? To save money. (A homeowner refinances his or her home at a lower mortgage rate for the same reason.)
Interest rate changes affect bond prices in the opposite way. Declining interest rates usually result in rising bond prices and vice versa -- think of it as a seesaw relationship. What causes this change? When interest rates rise, investors flock to new bonds because of their higher yields. Therefore, owners of existing bonds reduce prices in an attempt to attract buyers.
Investors who hold on to bonds until maturity aren't concerned with this seesaw relationship. But bond fund investors may see its effects over time.
Interest rate changes can also affect stocks. For instance, in the short term, the stock market often declines in the midst of rising interest rates because companies must pay more to borrow money for expansion and capital improvements. Increasing rates often impact small companies more than large, well-established firms. That's because they usually have less cash, shorter track records, and other limited resources that put them at higher risk. On the other hand, a drop in interest rates may result in higher stock prices if corporate profits increase.
So why do some stocks increase in value even as interest rates rise, or vice versa? Because industry or company-specific factors -- such as the development of a new product -- can impact stock prices more than rate changes.
Is there anything an investor can do when faced with interest rate uncertainty? You bet. Although you can't change interest rates, you can assemble a portfolio that can potentially ride out the inevitable ups and downs. Risk reduction begins with diversifying your investments in as many ways as possible.
Let's start with equities. Consider investing across different sectors, because no one knows which of today's industries will fuel the next expansion. Also be aware that some sectors -- such as energy -- are more economically sensitive than others, which can lead to increased volatility. Additionally, consider stocks or stock mutual funds that invest in different market caps and have different investing styles, such as both value and growth investing.
On to fixed-income investments. Do your bond funds hold bonds of different maturities -- short- and long-term -- and types, such as government and corporate? Different types of bonds react in their own way to interest rate changes. Long-term bonds, for instance, are more sensitive to rate changes than short-term bonds.
Interest rates will always fluctuate in response to economic conditions. Rather than trying to guess the Federal Reserve's next move, why not concentrate on creating a portfolio that will serve your needs well -- no matter which way rates go?