How interest rate changes can affect your investments
Rising or declining interest rates have a different impact on different types of investments, which can impact your portfolio.
Rising interest rates mean you receive higher interest on the money in your savings account or on that GIC you just purchased. But it also means that your mortgage rate could go up, your car loan could be more expensive, and your stock portfolio could dip.
So, when the Bank of Canada and other central banks adjust interest rates, particularly if they are making several moves over a relatively short period of time, it’s a good idea to pay attention.
How do interest rates work?
Interest rates are the amount a borrower pays a lender to borrow money. For example, if you want a loan for $1,000, the lender might charge you an annual interest rate of 5%. This means that, in addition to eventually having to pay back the $1,000 to the lender, you will also pay the lender $50 each year.
It works similarly for an interest-bearing investment. When you invest in guaranteed investment certificate (GIC), you are lending the financial institution your investment capital at an annual interest rate. In that case, they need to pay you the interest on their loan. For example, if you invest $1,000 at an annual interest rate of 5%, the financial institution must pay you $50 each year on top of paying back your principal at the end of the GIC’s term.
How are interest rates determined?
All central banks – the Bank of Canada, the U.S. Federal Reserve Board, the European Central Bank, Bank of Japan, etc. – set their respective policy rates based largely on the health of their economy and the level of inflation.
Canada’s central bank, the Bank of Canada, plays a critical role in our financial system, setting interest rates, helping to keep inflation stable, managing the money supply, and generally promoting “the economic and financial welfare of Canada”.
The Bank of Canada’s policy rate (also called the “overnight target rate”) is the interest rate that Canadian banks use to borrow from each other. While the borrowing rate between financial institutions may not appear to have much impact on the general public, it’s the ripple effect to other interest rates that impacts everyday consumers and businesses. When the Bank of Canada’s overnight rate changes, other interest rates follow suit – including mortgage rates, GIC rates, and savings account rates. And when these other interest rates change, it affects how Canadian consumers and businesses spend or borrow money, the demand for goods and services, and even what people invest in.
Why do interest rates rise and fall?
One of the biggest reasons for interest rate movements is the rate of inflation. Central banks use interest rates to control the level of inflation. If the economy is expanding, and inflation is rising too quickly, a central bank can raise interest rates to make it more expensive for businesses and consumers to borrow money. This usually slows spending and cools the economy. As demand declines, prices usually follow suit and helps to slow inflation.
However, if a central bank wants to stimulate the country’s economy, it will often lower interest rates to make it cheaper for businesses and consumers to borrow money. This helps to encourage borrowing and higher spending.
How do interest rates affect stocks?
When interest rates rise, most stock prices tend to fall. In a rising interest rate environment, companies must pay more to borrow money. This will have a knock-on effect on how much a company must pay for raw materials, in wages to its employees, or in financing upgrades to its equipment or technology. Rising costs generally lower a company’s profits, which often lead to a dip in its stock price. In a rising interest rate environment, investors may also sell stocks as bonds or other fixed income investments become more attractive, which can impact a stock’s price.
Of course, much depends on a company’s sector. The financial sector for instance, benefits from rising interest rates, and bank shares often rise because of increased profit margins. However, the real estate sector tends to perform poorly in a rising interest rate environment. Rising rates means higher mortgage rates, which tends to cool the real estate market.
These principals also apply to any product that invests in stocks, such as an equity-based exchange-traded fund (ETF) or equity mutual fund.
How do interest rates affect bonds?
Buying a new bond in a rising interest rate environment means you are paid higher interest. That’s good. However, the price of any existing bond you own may fall. If the bond you own was issued at a lower interest rate (also known as a “coupon rate”) than what you would receive on a new bond, your bond price will decline. Usually, as interest rates rise and fall, the farther away the bond is from its maturity date, the larger its price change will be.
Many Canadians invest in bonds through mutual funds or ETFs. When interest rates rise, the price of the lower-yielding bonds held within these investment vehicles will decline.
Should I shift investments when interest rates change?
The rise and fall of interest rates will likely have an impact on your investment portfolio. But before you make any decisions on the asset mix in your investment portfolio, consider whether your asset mix is still appropriate to your financial goal, risk tolerance and investment time horizon. Switching out of stocks or bonds when interest rates move could have a significant impact on your long-term investment returns.
Find out more about asset allocation.
The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This material is for informational and educational purposes and it is not intended to provide specific advice including, without limitation, investment, financial, tax or similar matters.