How rising rates are impacting investments – The Royal Gazette

By on April 30, 2022 0

Impact on investments: the price of fixed income securities, such as bonds, falls when interest rates rise and vice versa

This is the fifth and final in a series of articles to mark Financial Literacy Month.

Inflation is insidious. It decreases monetary value, purchasing power, slows spending, increases costs, all with various impacts, deleterious or beneficial on households, industries, capital markets and governments.

How is inflation controlled?

The US Federal Reserve, along with the central banks of other countries, is the regulator of an economy whose role is to provide stability, to smooth (so to speak) interest rates, prices and stability employment. Currently, their job is done for them, because according to various financial gurus and statistical evidence, inflation in the United States is the highest in 40 years.

The Fed uses many monetary tools: open market operations (OMO), the federal funds rate (FFR) and the discount rate (interest rate) to maintain this serenity.

OMO is the Fed’s process of buying from and selling to its member banks, typically by trading US Treasury bonds to free up capital for expansionary supply or to tighten capital now available.

The FFR is the Fed’s interest rate that banks charge themselves for overnight lending, differentiated from the discount rate set by the Fed to allow banks to borrow from the Fed to manage their reserve requirements.

The Fed changes its monetary and credit policy so that these institutions in turn pass on the impact of the increase (or decrease) to all types of consumers, services, and product producers.

The impact: Money and credit used to be cheap, now they are much cheaper.

Impact of rising interest rates on bonds

Bonds, usually a fixed income debt security, can be sovereign, government, corporate, etc.

Fluctuations in interest rates, even minute moves, drive bond volatility on global bond trading platforms – which are five to seven times larger than stock markets.

Why? There is an inverse relationship between the price of a bond and interest rates.

When a bond or note is first issued in the capital markets – say four years ago (2018), it is rated at face value, i.e. 100% – for example, a bond price of $1,000.

It is also given a fixed interest rate (coupon) which carries and is paid throughout the life of the bond until its maturity date, say ten years. In a pure issue, the interest rate and the bond yield are the same. The 2018 interest rate remains at 2%, per annum, regardless of whether interest rates in the economy go up or down.

More importantly, at maturity, a bond investor will receive their $1,000 amount, assuming the bond is of high credit quality.

Currently, interest rates in all capital market environments are rising. This means that new bond issues in 2022 will pay a much better interest rate, for example 3% or more. Investors will want the new 2022 bond, not the old one at 2% interest and could sell it, taking a loss.

Why would anyone want a 2018 low interest rate bond in a high interest rate environment? The price of the bond is reduced below $1,000 (100%), say to just $800, a bargain; this pricing compensates for the drop in interest rates, but how?

The pay-off at maturity!

The investor who buys the 2018 bond still receives the 2% interest rate for the term of the bond and at maturity receives 100% of the face value, $1,000, even if he doesn’t only paid $800. This $200 profit is a very simple example to explain yield – the interaction between the current price of a bond and its fixed interest rate (coupon).

Impact on shares

Publicly traded stocks, from micro-enterprises to large companies of all forms, are impacted negatively or positively, but require a different perspective than bonds.

Stocks represent the valuation of companies in open markets and are subject to many influences, including: higher cost of debt, especially with variable interest rates, consumer trends and demand, outlook growth appreciation, obsolescence, production supply chains, future earnings and competition from offers such as new certificates of deposit – with higher interest rates and less volatility.

Various investment websites note that financial stocks may do well as underlying companies may raise interest rates on credits/loans, while others have stated that investing in stocks is expected to focus on the fundamentals of the entity.

Ultimately, debt management will delineate the successful business and its stock value relative to its peers. Another article about this is coming soon.

Impact on raw materials

Commodities are one of the main classes of investment assets, such as:

• Wheat, corn, soy or other bulk foods

• Cattle or other livestock

•Cotton

• Lumber

•Sugar

•Precious metals

• National and foreign currencies

• Coal, oil and other fossil fuels

Commodity prices and interest rates have an inverse relationship, all based on the cost of holding inventory: high interest rate, lower commodity prices, as producers will only buy when needed and vice versa. The cost of supply and/or supply shortages – in Ukraine’s ongoing invasion environment – are also changing prices in unpredictable ways and are reflected in the stock prices of companies in the commodities sector. .

Impact on cryptography

According to Simon Chandler of CryptoVantage, higher interest rates generally mean a lower appetite for high-risk/high-reward assets such as cryptocurrencies, so the market should brace for a parallel rise in interest rates. aversion to risk.

Impact on personal households

According to Investopedia: “When credit card and mortgage interest rates go up, the amount of money consumers can spend goes down.”

Households still have to pay for health care, food, housing, insurance, transport, communications, etc. Very often wages do not rise with inflation, so savvy households reduce spending by reducing demand for goods and services; such actions impact the company’s cash flow and net earnings, producing a ripple effect on stock valuations.

Readers, here is financial literacy in action.

Financial literacy wellness is a very important part of understanding and paying attention to the big picture. What happens there ultimately impacts us.

It’s not just about better managing your personal finances. The best result is fundamental success because you are able to anticipate future financial impacts, giving you much more control over your personal finances.

References

How the Federal Reserve Controls Inflation: How the Fed Uses Its Tools to Manage Prices, Kimberly Amadeo, thebalance.com

How do interest rates affect the stock market? By Mary Hall and Somer Anderson, Investopedia

Higher Interest Rates and Commodity Prices, Andrew Hecht and Michael J Boyle, The Balance

Martha Harris Myron JSM is from Bermuda and has connections to the United States. She is an Amazon/Apple published author of The Dawn of New Beginnings: A Back-2-Basics Financial Review to Dramatically Improve Your Lifestyle – Book One of The Bermuda Islander Financial Planning Primers Series and a Google News contributor.