Interest rates are probably the primary driver of our portfolio action today—and much stock market action. But it’s important to remember their importance in context.
Interest rates are set by The Federal Reserve, which we refer to most often as “the Fed.” The Fed was established back in 1913 to create a financial system that could stabilize price levels and maintain interest rates. It’s America’s central bank. It has many purposes, but these are the ones most important to our current subject: interest rates.
The Fed is more of an influencer than a dictator of interest rates. It doesn’t control them, instead it influences money and credit in a way that gets consumers to spend more or less. Their goal is to boost the economy, and use the tools available to them to do this.
High interest rates aren’t usually a good sign for investments (with some exceptions below). But it’s never worth a panic, because though interest rates will rise, increases are usually moderate, occur over time, and rarely go as far as most people expect. So while it’s important to keep in mind the impact higher rates have on your holdings, it’s also important to remember that at the end of the day, not that much is going to change. A high quality company that earns reliable income and passes it on to investors is always going to be a good investment, regardless of interest rates.
Industries Most Impacted by Interest Rates
In general, businesses that have reasonable debt levels and plenty of cash stand to prosper as rates increase. Industries that should see increased investor interest include defensive sectors, large technology companies, and financials. Investors may want to avoid companies heavily dependent on debt, as defaults, eventually, will rise. As well, speculative ideas may be very volatile and risky.
There are a few investment sectors that are impacted by interest rates, detailed below.
Insurers are one of the few types of income investments that actually benefit from rising interest rates. That’s because most insurers make the bulk of their money not from taking in more in premiums than they pay out in claims (although that’s also important), but from investing those premiums while they have them. But they have to invest them safely, since they’re on the hook for payout. When yields on safe fixed income investments are higher, insurers can make more on their investments without taking on any additional risk.
On the other side of the spectrum, several sectors can be impacted negatively for the following reasons.
Utilities are affected by interest rates for two main reasons. First is their borrowing costs. Utilities have to make large investments in infrastructure like plants and distribution networks, but they have slim margins. So most borrow heavily to make investments. Because of their reliability—demand for their services is quite inelastic—most are investment grade borrowers despite their high levels of debt.
Interest rates also affect utilities because of something we’ll call the “substitution effect.” When yields on low-risk fixed income investments like treasury bonds are low, investors and institutions have had to look elsewhere for low-risk income investments. Utilities, with their good yields and relatively low volatility, are a fairly close substitute.
REITs, or Real Estate Investment Trusts, own real estate and pass the rents through to investors as distributions. REITs are negatively impacted by rising interest rates in the same ways as utilities—their borrowing costs go up, and they may become less important to investors. However, history has shown that REITs tend to outperform in times of rising interest rates anyway, for one simple reason:
Interest rates only increase when the economy is expanding, and when economic growth is strong, REITs see demand for their properties increase, and they can raise rents.
Business Development Companies (BDCs) are in the same boat as utilities, with one wrinkle. In addition to raising their borrowing costs and making them less attractive relative to fixed income, higher interest rates may also reduce the demand for BDCs’ services. BDCs, or Business Development Companies, lend money to and invest in small and medium-sized businesses. Some analysts argue that low interest rates create demand for their services because it makes larger financial institutions less inclined to lend to these businesses—since the yields aren’t that high.
The Current State of Interest Rates
Interest rates have been trending down since 1981, so while a reversal will impact many asset classes, it won’t happen overnight. Income investors—like all investors—should stay informed about the factors affecting interest rates, without overreacting to every wiggle.
Inflation is the number-one driver of higher interest rates. Inflation has been tame since the financial crisis, but economists expect it to pick up. While measures of current inflation are still below the Fed’s target, expectations have risen sharply, driven by strong U.S. and international economic growth, the lowest unemployment rate in years, an uptick in wages, the highest oil prices in years, and weakness in the U.S. dollar.
What else would you like to know about rates and how they impact investments? Leave a comment below!