What now, now that interest rates look like they’re rising?
The BoE recently dropped its biggest hint yet that it could raise interest rates by the end of the year, and perhaps as soon as November. It would appear to signal the end of super low rates and the beginning of the return to normality.
To help investors decide what they should do, I’ve written this series of four blogs. In the next three blogs, I’ll be discussing the impact of higher interest rates on property prices, how property investors can prepare for higher interest rates, and why investors should buy property as interest rates rise.
In this first article in the series, you’ll learn what higher interest rates mean to your investment portfolio.
Have investors become complacent in the low-interest rate economy?
We’ve become used to low-interest rates. The BoE began its low-interest rate policy in mid-2007. Lower rates were the life jacket that stopped the economy from drowning as it was buffeted by the storm of the Global Financial Crisis. During the last ten years, the BoE base rate has fallen from 5.75% to just 0.25%. In all this time, they haven’t been increased once. Investors have become used to asset prices never going down, as investors have chased yield.
Why could interest rates rise?
Central banks use interest rates to help control inflation and boost economic growth.
When the Global Financial Crisis put the global economy into a tailspin, central banks around the world cut interest rates aggressively. They wanted to prop up the economy by encouraging people to borrow and spend. Lower interest rates mean it’s cheaper to borrow, and lower rates of return on cash savings accounts mean it’s less worthwhile having cash savings.
If the economy is growing quickly, or inflation is taking off, central banks will increase interest rates. Higher rates make it more expensive to borrow money, and higher cash savings rates make it more attractive to hold cash in the bank.
The BoE base rate affects consumer spending, business investment, costs of borrowing, inflation, and the economy. It also affects investors.
When the BoE increases interest rates, it’s good news for cash savers (if the banks raise their savings rates, of course). But savings rates have been so far below the rate of inflation for so long that deposit account balances have been eroded. Instead of saving cash, people have either spent their money (to avoid the negative impact of low savings rates and higher inflation on spending power) or invested in other assets.
Hence, if higher interest rates are on their way, it will pay to understand how your investment portfolio might be affected.
How higher interest rates affect different investment assets
If you’re invested in a diversified portfolio, you will probably own a mixture of cash, equities, bonds and property. We’ve seen how cash savings become more attractive as interest rates rise, but how might other assets be affected?
Higher interest rates are a double-edged sword for equities. On the one hand, if rates are rising because of a vibrant and buzzing economy, it could mean that companies are making bigger profits. They may have the finances to pay bigger dividends. Higher profits and increasing dividends tend to result in higher stock prices.
However, higher interest rates also push up companies’ borrowing costs. And they reduce the amount of money consumers have available to spend. It could mean that profits are squeezed, dividends follow suit, and stock prices fall.
Heavily indebted companies could be hit hard. Other companies that are most commonly adversely affected by rising interest rates include utilities and commercial property companies. These are popular investments for income seekers, especially in a low-interest rate environment. However, they could be hit hard if interest rates rise aggressively. Some income seekers may turn to bonds, as they could provide a more stable stream of income. But would they be right to do so?
The correlation between bond yields and interest rates is higher than for any other asset. Rising interest rates mean higher bond yields and falling bond prices.
Longer-dated government bonds could be affected most. Floating rate notes will be affected the least – as the amount of interest they pay moves in line with interest rates.
Property has some of the characteristics of bonds and equities. It’s an investment asset providing both growth and income. Performance is linked to interest rate changes and economic growth, and many other factors, such as the property fundamentals of shops, schools, transport links, major employers and major investment, and population growth and the demand for homes.
The link between interest rates and property prices is harder to determine than for other assets. If rates are rising because of a strong economy, property prices are probably rising too. Buy-to-let landlords also have the option to increase rents, offsetting interest rate rises. Commercial property investors and funds could be worst affected of all property investors as lease terms are agreed for years in advance.
How should you position your investment portfolio for rising interest rates?
If interest rates rise gradually, the impact on investment markets could be muted. The faster and higher they rise, the more impactful they will be. But that impact won’t be evenly balanced. Some assets will be affected more than others.
Unlike with other investments, the property investor is in control of their own fate. As you’ll see in a later post in this series, there are strategies that you can put in place that could increase your profits in property when interest rates rise. That’s one of the reasons many professional property investors aren’t put off by what the Bank of England says or does.
Live with passion,