Why are interest rates so important for investors?
The Bank of England sets out the cost of borrowing or lending money as if you were taking no risk.
This base rate influences how much depositors can get for their cash savings, and investors can use this to compare the returns they want from investments such as shares and bonds.
If cash pays a higher rate, then investors should expect a higher return from their riskier investments.
The impact on bonds is usually the clearest. Government bonds and lower risk corporate bonds are most sensitive to interest rate movements and the prices would generally fall in order to provide a higher income offsetting the interest rate rise.
Some areas of the bond market are not so sensitive to interest rates such as short-dated bonds – i.e those about to mature and return their capital to investors, while high yield bonds are more sensitive to the outlook for the individual company but with an eye to the health of the economy.
Rising interest rates have a mixed and changing impact on equities and this creates a more complex situation, made even more so by the financial crisis of 2008/09. Initially, rising interest rates are seen as a sign of confidence in the health of the economy, that consumer confidence is both strong enough and company profits are healthy enough to be able to tolerate a rise in interest rates. This is currently the position we are seeing in the US.
However, higher interest rates mean higher costs for both businesses and individuals. The effects of higher rates varies with each business depending on their nature. Defensive businesses are less sensitive to interest rates, while consumer discretionary businesses can suffer if household spending drops.
In addition, there are other factors to consider – a heavily indebted company is more sensitive to interest rate rises especially if they need to renegotiate the debt sooner rather than later.
Rising interest rates usually curb demand and cool an economy, with the view to avoid it overheating and help prevent inflation getting out of control. Often economies tip into recession as central banks are too slow to react and then overreact as they try to catch up.
So investors need to plan for both the positives of higher interest rates plus the potential for policy error and recession. Having a mixed portfolio of equities makes sense as forecasting the cycle is difficult.
Cyclical companies (banks, miners and oil producers such as Lloyds and Rio Tinto) should do well in the early stages, while defensive companies (utilities, pharmaceuticals and tobacco such as SSE, Astrazeneca and Imperial Tobacco) provide protection should interest rates impact consumer demand.
However, when interest rates are rising it is important to focus on the quality of the company. The financial strength matters more when debt costs rise as companies with stronger balance sheets have more options and can survive tougher conditions for longer.