The Learning Centre:
Rise and shine? Investing when interest rates rise.
Your investments are affected by interest rates – their rise, and their fall.
(Reading time: 4:05)
Interest rates confuse many investors. Why do they increase? Why do they decrease? And how do interest rates affect an investor’s choices?
Why the Bank of Canada raises interest rates.
The Bank of Canada (BoC) uses interest rates to control the economy. Raising its base rate, as it has done several times since 2017, controls inflation by limiting the supply of money circulating in the economy. This makes it more expensive to borrow. If it costs companies more to borrow, they might slow their expansion, which could negatively affect their corporate earnings and cause their share price to fall. If enough companies’ share prices fall, there’s an overall lowering of major stock market indices. When interest rates rise, the economy usually slows down as well, since many consumers cut discretionary spending to pay things like their mortgage.
On the other hand, when the BoC cuts the base rate, money is more readily available to borrow, stock prices tend to rise, and consumers spend.
Rising interest impacts asset classes differently.
“A diversified portfolio usually holds a mix of different asset classes (stocks, bonds, cash investments or their equivalents)” says Educators Certified Financial Planner professional Robert Johnston. “The amount of each asset class you hold in your portfolio is unique to you, and should reflect your financial goals, investment horizon, and risk tolerance.”
You and your Financial Advisor should discuss your mix of asset classes—‘asset allocation’—once a year, when your personal life changes (marriage, children), or during times of economic change, such as when interest rates are rising.
Stocks might decrease in value, but only temporarily.
Rising rates can adversely affect stock prices in several ways. Higher borrowing costs can mean that companies spend more to service debt, and less on capital investments, which can affect future earnings growth. If consumers are spending less because of higher interest rates and higher debt levels, it can cause corporate revenues and profit growth to shrink, and affect a company’s stock performance.
That being said, history has proven that returns of stocks exceed the rate of inflation over time. Over the past 20 years, the average inflation rate in Canada has been 2% (Statistics Canada), while the average annual performance of the S&P/TSX Composite Index was 11% (Bloomberg).*
When considering the stocks in their portfolio, investors should keep in mind WHY the BoC has raised interest rates – basically, because the economy is doing better and they want to control growth. Areas to consider investing in when interest rates rise include the financial sector (which is helped by higher long-term rates), and the industrial sector, which is tied to the economy.
Tip: Real Estate Investment Trusts own or operate income-producing real estate such as offices, residential, retail, industrial, hotels and senior living residences. Real estate is a natural inflation hedge because rents and values tend to increase when prices do.
Fixed-term investments: different strategies for bonds and GICs
Fixed income investments include bonds, Guaranteed Investment Certificates (GICs), treasury bills, bankers’ acceptances, and mortgage backed securities.
Bond prices and interest rates move like a seesaw—when one goes up, the other goes down—so fixed income returns may be affected in the short term. “However,” says Robert, “a strategic allocation to fixed income is considered by many to be a key ingredient in a well-diversified portfolio.”
Tip: Remember that, although long-term bonds fluctuate more than shorter term bonds, they also have a greater interest rate risk, which ends up decreasing the price.
GICs differ from bonds. They offer higher yields than government bonds, and are insured against default by the Canada Deposit Insurance Corporation for up to $100,000. In addition, with a technique called ‘laddering’, you can keep equal amounts in GICs with terms of one, two, three, four and five years, so you won’t be strongly affected by modest moves in interest rates up or down.
You need expert advice to keep your portfolio on track.
As shown above, there’s a lot to consider when deciding whether, or how, to modify your portfolio to reflect changes in the economy such as rising interest rates. The financial specialists at Educators Financial Group are always available to answer your questions and provide experienced and knowledgeable investment advice.
The information provided is general in nature and is provided with the understanding that it may not be relied upon as, nor considered to be, the rendering of tax, legal, accounting or professional advice. Please ensure to consult your accountant and/or legal advisor for specific advice related to your circumstances. Educators Financial Group will not be held responsible or liable for any losses, costs, damages or expenses incurred by reason of reliance as a result of the aforementioned information. The information presented was obtained from sources that are believed to be reliable. However, Educators Financial Group cannot guarantee their completeness or accuracy.