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Preparing your finances for rising interest rates

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Written by:
07/10/2014
The defining feature of the post-Crisis economic environment has been low interest rates, but it is now coming to an end: How should investors prepare?

Low interest rates have governed stock and bond market returns, created a lengthy bull run in income-generative assets and shored up economic growth, but policymakers in the US and UK are now preparing to raise rates, possibly as early as spring of next year.

The first thing to say is not to panic – interest rates rises are likely to be gradual and limited given the level of debt still held by households and governments in the UK. But it is worth trying to stay one step ahead in planning your finances.

Your spending

We have all got used to lower mortgage rates, which remain lower today than when interest rates first started to fall. However, this benign period will come to an end when interest rates rise. For those who would struggle if their monthly mortgage payments increased, the best option is to fix if possible. Mortgage lenders are still offering competitive deals and homeowners with reasonable deposits could expect rates of below 3 per cent for 5-year deals, and below 2 per cent for 2-year deals. The other option is to make overpayments, so that if rates rise, the overall cost of repayments are lower.

It is also worth turning attention to your bills. Higher interest rates will be reflected in higher interest rates on credit cards and personal loans. There is also a danger that it brings a risk of higher inflation and therefore higher household bills. It may be worth taking the opportunity to lock in fixed deals where possible, to ensure your spending is manageable.

Your savings

The rates available on savings accounts and cash Isas should move higher but are still likely to be low relatively to history. The top easy access cash rates remain at below 2 per cent, while inflation has been in the 1.5-2 per cent range. This may rise to 2.5-3 per cent for savings, meaning savers may just beat inflation, but they aren’t going to be making significant gains. Unfortunately, this means savers still need to look at equity or bond markets to generate a higher income.

Your investments

Bond markets have had a strong run, but this may come to an abrupt end if rates rise. However, different types of bonds will see more impact: At one end of the spectrum, developed market government bonds are the most exposed; at the other, high yield bonds tend to be less vulnerable. The longer a bond’s life, the more its price is vulnerable to changing interest rates. Also, the lower a bond’s coupon (which is usually a function of the company’s quality), the more interest rates have an impact. The situation may be muddied by the liquidity of bonds, usually more of a problem in corporate bond markets, which may exaggerate any falls.
Put simply, developed market government bonds are likely to struggle in a climate of rising rates and may not provide the security of income and capital return that investors expect. Corporate bonds are likely to fare better, but may be undone by more liquidity.

Stock markets

Interest rates are only likely to rise when policymakers believe that economic growth is well-established and wage growth more visible. This should help support stock market prices, though some volatility is likely in the early stages. However, there are some stocks that may be more affected than others:

If investors can get more income from ‘safe’ investments such as cash, it means dividend payouts from companies become less valuable. This may pose problems for companies with reliable, predictable dividends and earnings that have become extremely popular with investors. These became less attractive as the interest rates rises become a reality. It may lead investors to investments that offer greater capital growth.

In the longer term, higher interest rates will raise the cost of borrowing for companies, but most companies are in good financial shape, and with a few notable, indebted exceptions, are unlikely to take a significant hit.

Commercial Property

Commercial property has been extremely popular with investors over the past 12 months. It too may be hit by rising rates as the income it offers becomes less valuable. However, the rental income from which commercial property generates its returns is inflation-linked and will tend to rise with improving economic conditions. This means commercial property can continue to thrive in a higher interest rate environment.

In general

Rising interest rates will have an impact on individual investment portfolios, but there are threats and opportunities. Higher rates may pose difficulties for some asset classes and give ammunition to others. It is important to review a portfolio in light of the change in environment to ensure that it is not vulnerable to the worst effects of a rate rise and to minimise volatility.

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