Rising Rates and Your Portfolio

by | Sep 8, 2022 | Financial Wellness

News sites are flooded with negative reports about the state of the economy. One of the most common topics is the current pace of inflation and the actions the Fed has taken to mitigate it. In the first half of 2022, inflation has continued to set multidecade records and the Fed has raised rates significantly in response.

These rate increases are intended to curb the rampant inflation, but they can also have consequences for investment markets and, in turn, your portfolio. Investors who misinterpret these consequences can make costly mistakes. However, those who understand the impact of rising rates can withstand swings in the market and achieve long-term success.

How Rising Rates Impact Bonds

Interest rates can have a significant impact on bond investments. Bond yields are determined based on several factors including the risk associated with the issuer and the duration of the bond term. Market interest rates are another very important contributor to bond yields. As market interest rates increase, bond yields tend to follow.

Higher bond yields can have a positive impact on your future cash flows. When you purchase bonds at the new, higher rates, the income you earn from your investments increases. As such, the current rate hikes could benefit your portfolio in the long run.

In the short-term, however, your portfolio could see some negative outcomes. One of the key tenets of bond investing is bond prices move counter to bond yields. In keeping with this principle, prices for existing bonds could fall if bond yields are propelled upward by rate hikes. In your portfolio, this could mean that the bonds you currently hold lose value as new bonds are issued at higher rates. Fortunately, if you intend to hold your bonds until maturity, these fluctuations won’t impact your current holdings.

Often, investors incorporate bond funds into their portfolio rather than investing in individual bonds. Bond funds are a collection of funds packaged and sold as a mutual fund. These funds can include hundreds or even thousands of bonds. When one bond in a bond fund matures, it is often replaced by another bond that meets the criteria for the fund. As such, bond funds typically replace bonds more quickly than investors who hold individual bonds to maturity. Since bond funds are continually replacing the underlying holdings, bond funds may react more quickly to changes in interest rates, such as providing a higher amount of income faster than a portfolio of individual bonds.

How Rising Rates Impact Stocks

While rate hikes have a clear effect on bond yields, the relationship between interest rates and stock prices is more complicated. Higher rates can impact stocks directly, but their effects can be amplified through shifting consumer behavior.

Higher rates will almost certainly dampen consumer demand in some industries. For example, higher financing costs can dissuade consumers from making large purchases like homes or cars. Slower demand often translates to lower sales – and therefore lower stock prices.

However, this impact is not felt equally across all stock sectors. Stock prices for vital products and services like food and energy are often impacted to a smaller degree because consumers continue to purchase these items – even when costs rise. This is one of the reasons why value stocks tend to outperform growth stocks in a high inflation environment. In addition, some sectors are positively impacted by rising rates, like the banking industry. When rates rise, banks can charge more on their loans, so higher rates can be a boon for banking stocks.

One of the more direct ways that interest rates impact stock prices is through the valuation of anticipated future cash flows. This calculation is particularly important for growth stocks and seeks to arrive at a stock valuation by discounting estimated future cash flows. The discounting method utilizes a variable called the risk-free rate – e.g., the 3-month Treasury rate. As that rate rises, valuations of future cash flows can drop dramatically – often causing the prices of growth stocks to tumble as well.

Rising Rates Can Lead to Short Term Declines in The Value of Your Portfolio

Interest rate increases can negatively impact the prices of stocks, bonds, and mutual funds that contain these investments. As such, you could see declines in the value of your portfolio as rates trend upward.

If you are saving for a distant financial goal, it could be disheartening to see your portfolio values tumble during a period of rising rates. However, it is important to remember your goal and the steps you have already taken to achieve it. A properly diversified portfolio and a comprehensive financial plan can help you weather short term market fluctuations and achieve your long-term goals.

If you are retired and relying on your portfolio to supplement your income, a lower portfolio value could be frightening. In that case, your short-term investing decisions will depend on your individual portfolio and financial situation.

If you are relying on the dividend income from bond funds to supplement your other income sources, you could rest easier knowing that the income from new bonds – those that replace the maturing bonds in your portfolio – could grow during a period of rising rates. On the other hand, if you are heavily invested in stocks and you need to sell a portion of those securities to meet your income needs, it could damage your future retirement income. In this case, you should meet with your financial advisor to fine-tune your withdrawal strategy.

When rates are on the rise, it is especially important to maintain a relationship with an experienced financial advisor. With the right financial partner, you can understand how your retirement plan is impacted by rising rates and make the necessary adjustments to ensure your retirement plan stays on track.

Prepare For Rising Rates with Financial Fingerprint™ By Brookstone Wealth Management

When you need an experienced financial advisor to help you navigate the current market, look no further than Brookstone Wealth Management. Our advisors can work with you to create your Financial Fingerprint™ – a comprehensive wealth management program that is quick to assemble, easy to understand, and simple to modify as your circumstances change.

With Financial Fingerprint™, you can be prepared for changes in the economy and investment markets. In addition, you can be confident that your portfolio is diversified, risk appropriate, and designed to help you reach your financial goals.

At Brookstone Wealth Management, our focus is on coaching, teaching, and mentoring our clients. We believe that this is the best way to help you find your True North. To get started, contact us.