Understanding Interest Rates

Key Takeaway

How do fluctuating interest rates affect your investments? There’s really no simple answer. However, knowing how certain investments generally respond to rising and falling rates may help investors make informed decisions.

A Bond Lesson

Bonds and other fixed-income investments that you’re currently holding in your portfolio may not fare well during periods of rising interest rates.

The reason: Prices of previously issued bonds fall when interest rates rise, since newly issued bonds are paying interest at a higher rate.

If you want to sell your bonds, you will probably have to sell them at a discount to compete with the prices of the new issues. But that doesn’t mean you should give up on bonds when interest rates are rising.

If you purchase individual bonds, consider buying bonds with laddered maturities of one, two, and five years. Then, as your bonds mature,* you’ll be able to take advantage of the potentially higher rates offered by newly issued bonds.

If you currently invest in Bond Funds, the portfolio managers generally purchase bonds of varying maturities.

Stock Reaction

Rising interest rates tend to affect some industries more than others. For example, companies that produce consumer staples (such as paper goods) tend to remain stable when the economy slows.

On the other hand, higher interest rates may limit consumer spending, which, in turn, affects housing, automobile, and other industries.

Additionally, when interest rates rise, companies pay more to borrow money, thus reducing earnings. And higher yields may encourage investors to put more money into bonds and less into stocks.

Banking Benefits

Savings accounts, certificates of deposit, and other cash equivalent investments offer more attractive earnings when interest rates rise.

*Investors may lose money if bonds are sold before maturity.