Inflation has grown across the globe, causing governments to contend with rising costs and slowing economic development. Things appeared to worsen when numerous central banks boosted their primary lending rates in recent months.
Interest rates have risen as expected as a result of the change in this key rate. While we recognize that this raises borrowing rates, it also has an impact on your investments.
Should investors like you be concerned about rising interest rates? What should your investment plan be in such times?
First, let’s go over the relationship between inflation, interest rates, bond yields, and so on. Inflation and interest rates are directionally connected, which means that they tend to move in the same direction but with a lag.
Central banks want inflation to be positive but controllable. A negative inflation rate, often known as deflation, indicates slowing economic growth since consumers tend to pause/postpone their spending when prices fall significantly, resulting in a reduction in economic activity.
Inflation is fundamentally determined by the supply and demand for money. When the money supply expands, more money chases the same products, and when the money supply contracts, prices and inflation fall.
Changes in interest rates have an impact on the amount of money available in the economy.
When interest rates rise, so does the cost of borrowing. It raises the cost of borrowing. As a result, borrowing falls, and so does the supply of money.
The interest rate falls when there is low inflation. Borrowing will become less expensive as interest rates fall. As a result, borrowing will rise, as will the money supply. People will have more money to spend on products and services as the money supply expands. As a result, demand for goods and services rises, and with supply being constant, the price level rises, resulting in inflation.
Commodity prices have progressively climbed due to the prevailing tensions in the West caused by the Russia-Ukraine war, and inflation has continued to skyrocket. In retrospect, inflation is expected to continue over the RBI’s current target.
As a result, central banks have raised interest rates to curb inflation, further unsettling the bond market. This is why bond yields increased after central banks announced rate increases.
Effect on the Stock Market
It is well knowledge that equities are sensitive to changes in interest rates. Furthermore, the two functions are inversely connected. That is, when interest rates fall, stock prices rise, and vice versa.
When central banks raise interest rates, even if stock markets initially continue to rise, higher borrowing costs eventually begin to affect earnings.
Effect on Debt
Bond prices and interest rates are inversely proportionate, which means that when interest rates rise, bond prices fall. Furthermore, rising interest rates have an impact on all types of debt instruments. However, the impact is greater on medium to long-term obligations than on shorter-term debts. This is because the price variation in short-term instruments is quite modest.
As a result, debt instruments that invest for a shorter length of time perform better in a rising interest rate environment. Medium and long-term debt instruments, on the other hand, are seeing a price correction.
Effect on Equity Investments
Banks are forced to raise their lending rates as interest rates rise to owe to inflation. This increase in lending rates raises the cost of funding for firms and organizations, negatively damaging their financials.
The 10-year bond yield of governments represents the cost of debt. If yields grow, it is logical for the cost of capital to rise as well. This further reduces returns, making equities unappealing. As a result, when a rate hike appears to be on the horizon, equities markets adjust themselves.
Effect on Real Estate Investments
As has been observed in the past, if interest rates rise, property stocks lose value at least 60% of the time. If real estate expansion is financed through borrowings, higher interest rates raise the acquisition costs of new properties.
Rising interest rates can also raise the cost of capital for real estate investment trusts (REITs), leading to higher cap rates. A high cap rate can also reduce the net asset value of REITs, causing stock prices to plummet.
Where Should You Invest in a Rising Interest Rate Environment?
Invest Money: Bonds are currently being sold off due to expectations that the central bank would begin to cut its bond-buying program. This is why interest rates are increasing. When interest rates climb rapidly, shares begin to fall in value as investors fear higher opportunity costs and slower spending.
Cash becomes even more attractive during such periods, while other asset classes depreciate. Once you’ve determined your risk tolerance, it’s always a good idea to have a solid cash stack to begin investing back into equities and bonds.
Investments in short-duration funds:
You may choose to reduce the average duration of asset holding to reduce the sensitivity of your portfolio. When investing in a rising interest rate environment, consider bond funds with coupon rates that float with the market rate.
Get your debts under control:
Rising interest rates drive up the cost of being in debt. Do you have variable-rate debts or obligations that will force you to borrow more to pay them off when they mature? Now is the time to find out how to pay them off or lock in fixed rates. Variable-rate debts will become more expensive as interest rates rise. This will make fixed-rate loans even more expensive.
You may control more of your income and cash flow by paying off your obligations or financing them while interest rates are low. This helps to ensure that you have adequate funds to invest in the first place.
Invest in alternative investments: Investors might think about investing in alternative assets. Alternative investments are not market-linked and so mitigate volatility more effectively. Alternative investments, such as peer-to-peer lending, are a viable strategy to protect against stock market downturns. Furthermore, despite a rising interest rate scenario, it provides substantial yields. Aside from P2P lending, investors can look into invoice discounting, fractional real estate, and other options, but they should avoid organizations and areas that are badly impacted by rising interest rates.