Way back in 2021, the combination of vaccines and easing COVID restrictions allowed for businesses to begin returning to normal, and many to begin bringing on new staff members. At the time, it was a relief to see the economy recovering, and the markets responded accordingly. The S&P 500 finished 2021 up 26.89%, trailing only 2013 and 2019 for the index's best calendar year return of this century. However, nearing the end of 2021, many began to wonder if the return to work and increases in company revenues were happening too quickly. Some argued that the inflation spike was "transitory" and that 2022 would look more like a normal year. Others believed that the combination of government spending and historically-low interest rates could create longer-term issues in the months and years to come.
As it turns out, those thinking the latter were proven correct. Inflation not only remained elevated beyond its historical average, but it nearly doubled based on the previous year's CPI (4.7% in 2021 compared to 8.0% in 2022). As a result, we watched the Federal Reserve raise rates an unprecedented eleven times in less than 18 months. While this did help ease inflation in 2023 so that we could start inching closer to the Fed's 2% target, we still have a ways to go. As a result of this, the conversation of "higher for longer" has been a common one to start 2024. We all know what that means for someone who wants to take out a loan or start a savings account, but what happens to your portfolio when rates are higher for an extended period of time? More importantly, what opportunities might exist in a scenario where rates remain unchanged for longer than we expect? Below, we will break down the impact of interest rates on both stocks and bonds.
Stocks
Interest rates and the stock market are commonly spoken about together, but how do the two actually impact each other? Given that a stock is simply ownership in a company, it helps to think about the actual company itself. If the company's goal is to increase its value to reward its shareholders, how would higher interest rates change anything? The largest impact is in a company's ability to raise additional funds through the use of debt. Just like we all now have to pay a higher interest rate to borrow for a car, a home, or education, companies are similarly at the mercy of the Federal Reserve's rate policy. With higher rates, less money can be borrowed, and the impact can be seen in a variety of areas. Some companies will cut future growth goals and hold off on areas like Research & Development, which would then reduce future cash flow expectations for the company. Additionally, if a company is forced to take on a large amount of high-interest debt to pay for short-term expenses, this could vastly reduce the current year's earnings.
Borrowing money is not the only issue caused by higher rates. If you take a short drive around town, you will likely notice that most banks are advertising some type of CD or savings account offering a great rate of interest. With the Federal Funds rate over 5%, yields are at levels that we have not seen in over a decade. When that happens, individuals tend to start leaving more cash than they normally would at the bank. While lower interest rates tend to force more investors into the market to at least get some type of yield on bonds or dividend-paying stocks, higher rates allow for investors to still gain some interest while not having to worry about the risk that publicly traded investments inherently take on. In our current higher rate environment, this means that less money is flowing into the market, so less investors are available for companies that would like to issue shares to the public.
Bonds
We just wrapped up how companies have a harder time borrowing when rates are higher. Given that a bond is simply debt issued by an entity in return for a specified rate of interest, the bond market itself is heavily tied to interest rates. However, there are two different ways to view the impact of a rate increase on bonds. First, for bonds that you already own, the price will actually go the opposite direction of interest rates. So if rates were to rise, your bonds in your portfolio would decrease in value. If rates fall, that would increase the value of the bonds. Since bonds are intended to pay the investor interest, why would this be the case? Here is a hypothetical: say you purchase a bond from company ABC that paid you 5% annual interest per year. What if the Fed decided six months later to raise rates from 5% to 6% so that newly issued debt would be paying roughly 1% more? Now, company ABC would be issuing new bonds at closer to the 6% Federal Funds Rate, making your previously-purchased bond at a lower rate less valuable on the open market. If rates were to do the opposite and decrease from 5% to 4%, newly issued bonds would now be paying roughly 4%, so your previously-purchased 5% bond would now increase in value since it is paying more than these new bonds.
Regarding newly issued bonds, this is where rising and/or elevated interest rates can actually be a positive. With rates at higher levels like they are now, there are plenty of opportunities to explore corporate bonds, municipals, treasuries, or even CDs that are available at much more favorable rates than what we have gotten used to seeing in recent years. With these elevated rates, and potentially the ability to lock them in for multiple years, it can be tempting to set a rate that you do not have to worry about and avoid the increased volatility that comes with investing in the stock market. That being said, even locking in rates for longer periods can come with risks. The first would be interest rate risk: if you own a bond that matures in ten years, and another bond from the same issuer maturing in one, the ten year bond's price will fluctuate much more as interest rates change. This is because the bond will pay its stated rate for a longer window of time, whereas the one-year will be maturing soon. Once it matures, you can then reinvest at the new rates, so a change in the interest rate environment would be much less important. Additionally, with all debt that is issued, you have reinvestment risk. This is the risk of having your bond mature at a time when you cannot reinvest the funds at the same rate and/or for the same credit rating, timeframe, etc. The last of the major risks that we will discuss is credit risk. Especially as you venture into areas of higher-yielding debt, you begin to run the risk of that entity not being able to fund the commitments that were made to those purchasing the bonds. When this happens, there is a chance that the principal you invested could never be repaid, even if you were to hold the bond to maturity.
What Now?
We have gone over the various impacts that interest rates can have on both stocks and bonds. Once that is clear, the next question should be: what do we do with this information? As with nearly all financial planning topics, the answer is that it will vary from case to case. There would never be a situation where everyone should be buying a certain type of bonds or stocks, because everyone is dealing with different risk tolerances, investment time horizons, liquidity needs, and many more factors. What is important is to evaluate your current portfolio, and ask yourself how much of the risks that we discussed are being taken on by your investments. Additionally, it is a good opportunity to evaluate the aforementioned characteristics of liquidity, time horizon, and risk tolerance as they pertain to your overall financial plan. Maybe you are considering increasing the duration of the bonds, treasuries, or CDs that you own; additionally, you might be wondering if keeping cash in a bank account with a good interest rate makes sense long-term compared to other riskier investments. The reality is that all of the answers will come back to what makes the most sense for your overall financial plan. As always, creating an optimal plan for your exact needs and values is at the core of what we do. If you would like to reevaluate your plan, or even if you are someone who has never truly completed a full financial plan, we are always happy to help.
Matt J Black,CFP®, AAMS®
mblack@larsonfs.com
913-428-2233
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