Investors are drawn to investing primarily due to its high interests. No matter how minimal the risks are, any other forms of investments are not even considered without a rewarding income. To these investors, high interests mean that the investment is healthy and has no negative impact on their finance or the economy. They fail to see the influence of high interest on the investment itself and the economy in the background. This article will look at some of the effects high interest can have on the economy and other financial areas, alongside its opposite - the low-interest rates.
Interest rate on investment is a form of income that the investor receives for lending his money to the borrower. Many invest their money to hedge against inflation and prepare for early retirement, as regular savings accounts become insufficient to grow wealth. Usually calculated on an annual basis, investors put their money into various assets like bonds, equities, funds, deposits, and real estate in their portfolios. Therefore, high interests in their investment are highly attractive to investors because it makes the investment worth the time and wait.
However, both high and low interests have long-term consequences for the investor and the issuer. Whether you take it positively or negatively, high interest rates can affect the following assets in the portfolio:
A bond is a debt instrument, a tool through which the buyer lends money to the borrower or issuer by buying the bond for a period of time. Throughout the period, the bondholder is paid a fixed interest, after which the borrower pays the principal back to the investor. An issuer could be the government or a company, and in both cases, they are issuing bonds to gather capital for their projects.
The relationship between bonds and their interest rates is contradictory. As such, when the interest rates rise, prices of bonds fall, and when the interest rates fall, prices increase. This is because when the issuer is offering new bonds with better interest, no sane investor will buy the bonds with a lower interest rate. As a result, the lack of demand for the previously issued bond causes its prices to fall as investors flock to the bonds with the higher interest rate. This can both be a positive or a negative thing, depending on which side you are on. If you are a bondholder looking to sell his holdings, an increase in interest rates may not be recommended because the price has decreased. On the other hand, it is good news for the buyer because the prices are low, and you can buy the low-cost bonds, even though the interest rate is low.
An increased interest rate in bonds, particularly coming from companies, could mean higher risk. That is because companies with lower credit ratings are more prone to defaulting and hence they offer bonds for higher interest rates to invite more investors. Such bonds are known as junk bonds or high yield bonds and they could be both good or bad, depending on whether the company defaults or continues to pay until maturity.
The relationship between interest rates and stocks is less direct than bonds because interest rates affect debt instruments more closely. Stock is an equity instrument, meaning it lacks the borrowing aspect. An increase in interest rate for stocks has a positive outcome - more people buy their stocks because of high interest rates. However, companies may also see less profit because they are paying their stockholders more. Worse if the company heavily relies on consumer spending because if consumers were to lose their ability to spend more, companies would also lose their profit margin, which supplies the companies’ interest rates to the stockholders. Regardless, it could lead them to make few bad decisions, which would result in a downturn in the interest rates of stocks, such as:
Overall, an increase in stock interest rates has to be supported by a large customer base to ensure that the profits keep coming and lower debt so that the issuer does not have to spend more on loans.
Your savings account and certificate of deposits are more a buffer for emergency costs rather than investment. Therefore an increased rate of interest can only be a good thing for you. However, a bank might impose certain restrictions on you, such as restricting access to the money by stipulating a period to keep the money in the account. You will not be able to withdraw anything within the time period. Otherwise, you will lose all your interests. Other restrictions could be a fee that you could be charged if you withdraw. Such conditions are not uncommon, and many credit unions implement them. However, in the end, the increase in interest is the bare minimum, up to 1%, and is not sufficient enough to cover the loss from inflation, i.e. 2% annually. Therefore, both savings and investing are recommended.
Similar to bonds, commodity prices have an inverse relationship with rising interest rates. When interest rates increase, the prices of the commodities decrease and vice versa. Commodities commonly include gold, oil, and natural gas. Their close correlation is due to the cost of inventory of the commodities, meaning if the cost is lower, there is more to pay in interest. The same applies to the fund of commodities, for e.g. an ETF in a commodity. If you invest in commodity-based ETFs and the storage cost of the actual inventory is low, your interests earned will be much higher because there is more profit to spare.
However, it is important to note that, unlike bonds (where interest rates and prices determine the attractiveness of the bond), the rise in interest rate results from low-cost inventory, not the other way around. High interest rates do not lead to low costs. Rather low cost leads to high rates.
Most investors ignore the results of rising interest rates. Unless they are not affected negatively, they would likely continue to ignore it. Investors do forget that rising interest rates on investments tell a lot about the issuer - whether they are in a good position to pay such an amount or they are taking a high risk. It typically means a growing economy where the investor earns a good rate. However, investors should be familiar with the impact of higher interest rates so that they can prepare to minimise any potential risks.
Last update: 10/08/2021