Derek, how should I invest if interest rates start to rise?
The topic of rising interest rates has been persistent since the 2008 financial crisis where we entered a period of historically low rates. It seems that everyone has been expecting interest rates to increase since that time, despite rates remaining stubbornly low. However, the US Federal Reserve now seems to be interested in moving rates higher as their economy is notably stronger. As always, investors should look at their long-term objectives before adjusting their portfolios, but there are some considerations when looking at higher rates.
Companies who lend money to consumers or companies tend to benefit from higher interest rates. Usually their profit margins increase as interest rates increase, thus making more money and in turn their shares increase in value. While this is an overly simplistic view, it means you may want to consider having a position in the financial sector, namely banks that are in the loan and mortgage business.
Other companies who benefit from higher interest rates include insurance companies. Generally speaking, insurance companies have large amounts of deposits earning interest so they have cash available if they need to make a payout for a claim. Higher interest rates mean these companies can earn more interest on their underlying investments, which in turn helps their profits.
Another sector that tends to benefit from higher interest rates is the consumer discretionary sector. These are companies that sell products that people want, rather than need. While not as linear as banking and insurance, consumer discretionary companies tend to benefit because higher interest rates tend to mean that the economy is stronger, people are getting paid more, and they are finally eager to spend their new found income on things like home improvement, that hot new electronic device, and perhaps a fresh new wardrobe.
With this information in mind, it’s important to consider which sectors may suffer from higher interest rates. As one might expect, companies that tend to carry large amounts of debt for their business needs are often hurt by rising interest rates.
Companies in the telecom and utility sector tend to underperform with rising interest rates. Normally, these companies have large amounts of debt to pay for their massive infrastructure (think of power lines, underground cable networks, and pipelines). Rising rates means they will end up paying more interest and thus generating less profit.
Similar to the telecom and utility sector, real estate investment trusts or REITs normally suffer in a period of higher rates. REITs are conglomerates of real estate holdings which can include residential and commercial properties. As you can assume, REITs carry large amounts of debt on their buildings. Rising interest rates mean their loan payments also increase which compresses their margins and eventually hurts their profits.
Finally, bonds normally do not perform well in a rising interest rate environment. In simple terms, this is due to the fact that newer bonds will be available at higher rates, which means that the bonds you have today will be valued less attractively. Since bonds usually are intended to guard your portfolio you may not want to sell them all. Perhaps you should reduce some exposure, or ensure that the bonds you have mature in the near-term allowing you to buy new bonds at higher rates.
Keep in mind that interest rates in Canada aren’t expected to rise anytime soon, but the spillover from the US may impact investors north of the border. More importantly, before making changes investors should have a serious conversation with a qualified wealth advisor to ensure their portfolio matches their risk tolerance and long-term objectives regardless of where interest rates may go.
Happy investing,
Derek Fuchs, senior wealth advisor, Scotia Wealth Management
This article is for information purposes only. It is recommended that individuals consult with their Wealth Advisor before acting on any information contained in this article.