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Effects of rising Interest rates on Investments
The rise in interest rates have a series of direct and indirect effects on different types of investment. In general, rise in interest rate have a negative impact on long-term values, but may have the opposite effect on short-term securities. Interest rate changes do not directly affect the actions, but the economic impact of these increases generally decreases the price of the shares.
1. Long-term instruments
Debt instruments are directly affected by rising interest rates due to the fact that the debt instruments are securities in which investors earn interest. These securities are in the form of bonds and mortgages. If you save a debt to maturity, you will receive a return of premium by the issuer of the debt. However, if you sell it to another investor before it reaches maturity, you might have to sell it at a reduced price if similar debt securities available at that price.
2. Short-term instruments
When interest rates rise, many investors diversify their funds to highly liquid, short-term bank certificates of deposit or money market accounts. If the types of short-term instruments are comparable to the rates of major fixed income securities, in the long-term, most investors would prefer the liquidity provided by short-term instruments rather than long term instruments that are illiquid.
Therefore, investment in instruments that pays good interest rate increases when the stock prices rises in the short term. Generally, the prices of short-term bonds are not affected largely by increase in interest rates because investors do not have to wait long for a return of premium and are unlikely to reach an agreement to sell at a discounted price.
3. Consumption expenditure
When interest rates rise, investors have to spend a higher percentage of their money in payment of debt because the interest rates of credit card, auto loan and mortgage lending rates begin to rise. As a result, investors need to reduce their other expenses due to a loss of purchasing power. This means that people have less money to invest and as stock prices are partly driven by supply and demand, stock prices fall every time investors have less disposable income.
Apart from supply and demand, prices of shares are also driven by the performance of companies that issued the shares. Investors who rely on income from dividends are negatively affected when dividends are cut and investors often tend to go to another type of values when cuts of the dividends are widespread.
When interest rates rises, loans become more expensive for businesses, as well as for people and this makes a fall in corporate profits. Lower profits lead to lower dividends and falling stock prices. Therefore, the increase in interest rates have a negative impact on the value of the shares.