How key interest rate increases will impact your investments

Interest rates directly or indirectly influence every type of investment, including those in equities, bonds and currencies. Depending on how your portfolio is constructed and what your financial goals are, interest rate changes can either have significant long-term repercussions or none at all on your investments. It all boils down to the way your portfolio is diversified and managed.

The key interest rate sets the minimum interest rate on interbank loans, which affects the interest rates of retail loans. The key interest rate is the Bank of Canada’s main tool to control inflation. When a central bank raises its key interest rate, it reduces the borrowing capacity of individuals and companies, slowing down the economy and moderating inflation. Conversely, in a sluggish economy, the central bank may cut its key interest rate to encourage borrowing and spending in order to boost the economy.

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The Bank of Canada tries to maintain inflation within a 1%–3% target range to ensure the Canadian economy stays the course. With persistent above-target inflation, the Bank of Canada has raised its key interest rate three times since January 2022.

While those hikes are making headlines, we must keep in mind that the current rate is historically low. In 2007, in the wake of the financial crisis, the key interest rate was 4.5%. Meanwhile, it topped 20% in the 1980s and neared 14% in the 1990s.

WOWA, 2022

Key interest rate fluctuations are among the factors affecting interest rates set by financial institutions. They also affect each of your investments in different ways.

Bonds

Bonds are debt obligations of variable duration issued by companies or public organizations to finance their operations. Key interest rate increases directly affect bonds. In a rising rate environment, new issues pay higher interest to the creditors, i.e., the investors.

As a result, the price of outstanding bonds falls due to the laws of supply and demand, because new bonds issued at a higher nominal rate are more attractive to investors than those already on the market. The latter’s value thus drops to reflect this new reality.

However, bond price fluctuations will have no repercussions if you hold a bond until maturity instead of selling it, as the debt will then be repaid in full to the creditors. Your bonds’ maturity also influences their sensitivity to interest rate fluctuations, with long-term bonds being particularly responsive. Consequently, when rates are raised, these securities react more strongly, as do their price and yield.

Equities

While interest rate fluctuations don’t have as direct an impact on equities compared to bonds, higher borrowing costs impair indebted companies, because their repayment costs also go up.

As a consequence, reinvestments to foster growth and profits paid out as dividends are reduced.

Moreover, higher interest rates can negatively affect companies’ net present value (NPV), which is one of the many ways to evaluate their worth. A company’s stock will move up or down on the market based on the value investors assign to it.

The higher the future cash flow growth (R) and the further in time the cash flow is expected (t), the more sensitive to interest rate fluctuations (i) the NPV will be. This is the case for information technology growth companies, for example.

Additionally, when interest rates increase, dividend-paying equities

What is net present value?

NPV is a formula used to represent the present value of a company’s future earnings

The higher the future cash flow growth (R) and the further in time the cash flow is expected (t), the more sensitive to interest rate fluctuations (i) the NPV will be. This is the case for information technology growth companies, for example.

Additionally, when interest rates increase, dividend-paying equities become less attractive, as it may be just as profitable and less risky to invest in bonds instead.

Currencies

Interest rate fluctuations also affect our currency’s value. Influencing factors include greater foreign interest in Canadian government bonds when interest rates go up. By purchasing such bonds with Canadian dollars, foreign buyers put pressure on the currency’s demand, thereby increasing its value.

Meanwhile, Canadian investors holding foreign investments see their value drop as a result of a stronger Canadian dollar. Conversely, a stronger currency causes import prices to go down. Certain markets, like retail, perform well in these scenarios, as cheaper imports generally lead to higher profits and can potentially boost importers’ stock prices.

We cannot talk about higher interest rates without also bringing up mortgage rates. This is probably one of your main concerns if you are about to negotiate a mortgage.

Key interest rate hikes lead to higher mortgage rates, which increase borrowing costs. Inflation, which is rocking the real estate market, is being curbed by raising the key interest rate. With regard to real estate, such an increase can substantially harm your financial situation if you are about to renew a variable-rate mortgage or are planning on purchasing a new home.

Clearly, interest rate fluctuations don’t have the same impact on every type of investment. This means that the best way to protect yourself is to diversify your portfolio.

Diversification is the cornerstone of any sound financial strategy. You can minimize your exposure to rate fluctuation risks by not concentrating your investments in only a few or similar assets. That way, you will be well positioned to take advantage of the post-interest hike environment.

Moreover, you can also lessen the impact of rate increases by investing in a range of asset classes, including equities and bonds with different maturities, and in a variety of sectors and geographic areas.

Engineering professionals can invest in FÉRIQUE Funds for which FÉRIQUE Investment Services is the principal distributor. Those Funds allow you to invest into various geographical sectors or asset classes in order to build a well-diversified portfolio. Five turnkey Portfolio solutions, each suited to a different type of investor with a distinct risk tolerance profile, are also offered. Under the supervision of FÉRIQUE Fund Management, the Funds are managed by proactive portfolio managers that know how to adapt to the economic reality and take advantage of the opportunities arising in a highly volatile environment.

If rising rates are hurting your ability to reach your financial goals, getting advice from a mutual fund representative or financial planner may prove very useful. Both professionals can help you make investment decisions tailored to your needs and your investor profile, while diversifying your portfolio. Moreover, as rate increases often bring economic uncertainty, such advice can protect you from making potentially costly emotional decisions.