Global inflation has risen, forcing governments to deal with growing expenses and weakening economic growth. Things got worse when several central banks raised their prime lending rates in recent months.
Because of the shift in the benchmark rate, interest rates have risen as anticipated. While we understand that this raises borrowing rates, it also has an impact on your investments.
Should investors like you be concerned about rising interest rates?
In such circumstances, what should your investment strategy be? First, consider the relationship between inflation, interest rates, bond yields, etc. Inflation and interest rates are inversely related, meaning they tend to move in a similar direction but with a lag.
Central banks prefer inflation to be positive but manageable. A negative inflation rate, often known as deflation, signifies decreasing economic growth because when prices decrease sufficiently, customers prefer to pause/postpone their spending, reducing economic activity.
The supply and demand for money determine inflation. More money pursues the same things when the money supply expands, and prices and inflation decline when the money supply contracts.
Interest rate changes influence the quantity of money accessible in the economy.
Borrowing costs rise when interest rates rise. It raises borrowing costs. As a result, borrowing and the money supply fall.
When inflation is low, interest rates fall. Borrowing will become more affordable when interest rates decline. As a result, borrowing and the money supply will rise. Consumers will have more money to spend on goods and services as the money supply rises. As a result, demand for products and services rises, and because supply remains constant, the price level rises, leading to inflation.
Commodity prices have risen steadily due to the Western tensions induced by the Russia-Ukraine war, and inflation has surged. In the long run, inflation will remain above the RBI’s present objective.
As a result, central banks have boosted interest rates to contain inflation, further agitating the bond market. This is why bond yields rose after central banks announced interest rate hikes.
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Effect on the Stock Market
Equities are well known to be sensitive to changes in interest rates. In addition, the two functions are inversely related. Share prices go up when interest rates fall, and vice versa.
Even if share prices initially continue to increase when central banks raise interest rates, higher borrowing costs eventually impact earnings.
Effect on Debt
Bond prices and interest rates are inversely proportional, which means that bond prices fall when interest rates go up. Rising interest rates also influence all sorts of debt instruments. However, the impact on medium to long-term liabilities is greater than on shorter-term indebtedness. This is due to the low price volatility of short-term instruments.
As a result, debt instruments that invest for a shorter period perform better in an environment of rising interest rates. On the other hand, medium and long-term debt instruments are seeing a price correction.
Effect on Equity Investments
As interest rates rise due to inflation, banks are forced to hike their lending rates. This rise in loan rates raises the cost of finance for businesses and organisations, affecting their bottom lines.
The 10-year bond yield of governments represents the cost of debt. It stands to reason that when yields rise, so will the cost of capital. This cut returns even further, making equities unprofitable. As a result, when a rate hike appears on the horizon, equity markets respond accordingly.
Effect on Real Estate Investments
According to research, property stocks lose their value at least 60% of the time when interest rates rise. Higher interest rates increase the acquisition costs of new properties if real estate expansion is financed through borrowings.
Rising interest rates can increase the cost of capital for real estate investment trusts (REITs), causing cap rates to rise. A high cap rate can also decrease REITs’ net asset value, leading stock prices to fall.
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Where Should You Invest in a Rising Interest Rate Environment?
Bonds are currently being sold in anticipation of the central bank reducing its bond-buying programme. This explains why interest rates are rising. When interest rates rise rapidly, stocks fall in value as investors fear higher opportunity costs and less expenditure.
Cash becomes even more appealing during such times as other asset classes decrease. Once you’ve assessed your risk tolerance, it’s always a good idea to have a healthy cash stack to begin investing in equities and bonds.
Investments in short-duration funds:
You might minimise the average duration of asset holding to reduce your portfolio’s vulnerability. Consider bond funds with floating coupon rates while investing in a rising interest rate environment.
Get your debts under control:
High-interest rates increase the cost of debt. Do you have variable-rate loans or obligations that require you to borrow more to pay them off when they mature? It’s time to figure out how to pay them off or lock in fixed rates. As interest rates hike, variable-rate debts will become more expensive. Fixed-rate loans will become even more expensive as a result of this.
You can control your income and cash flow more by paying off your debts or financing them while interest rates are low. This ensures that you have enough finances to invest in the first place.
Invest in alternative investments:
Investors may consider investing in alternative assets. Peer-to-peer lending, for example, is a reasonable strategy for hedging against stock market downturns. Alternative investments are not market-linked and hence more effectively minimise volatility. Furthermore, it gives considerable yields despite a rising interest rate situation. Aside from P2P lending, investors can consider invoice discounting, fractional real estate, and other alternatives, but they should avoid companies and places that rising interest rates have negatively impacted.
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