Interest rates play a significant role in the world of investing and can have a profound effect on the profitability and success of investments. Interest rates not only impact the cost of borrowing, but also the return on investment, and the value of various asset classes. Understanding how changes in interest rates affect investments is crucial for investors to make informed decisions.
In this article, we will unpack why interest rates are changed and start by looking at how it affects the bond market as an asset class. In the following two articles, we will look at the impact changing interest rates have on other asset classes such as saving accounts, equity, foreign investments and real estate.
Why Do Interest Rates Change?
Interest rates are changed by Central Banks such as the Federal Reserve in the United States, the European Central Bank in the Eurozone and the South African Reserve Bank in South Africa. Central Banks are mandated to use interest rates as part of their monetary policy to steer the economy when needed. They may raise interest rates to control inflation by reducing the amount of money in circulation, which can slow down spending and reduce demand for goods and services. Higher interest rates can make borrowing more expensive, which can also discourage spending.
They may also lower interest rates to stimulate economic growth and encourage borrowing and investment. Lower interest rates can reduce the cost of borrowing money, making it more attractive for businesses and individuals to take out loans and spend money on investments.
Many investors often overlook the fact that an important reason for Central Banks to intervene and change interest rates is to stabilise the value of their currency relative to other currencies. Higher interest rates can make a currency more attractive to investors, which can increase demand for the currency and raise its value.
Bonds
Changes in interest rates can have a significant impact on the bond market, as they affect the yield on existing bonds and the attractiveness of new bonds to investors. Here are some of the ways that changes in interest rates can impact the bond market:
Bond prices: Interest rates and bond prices have an inverse relationship. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. This is because when interest rates rise, investors demand higher yields to compensate for the increased risk of lending money at a higher rate. This means that the value of existing bonds with lower yields decreases, as they become less attractive to investors. Conversely, when interest rates fall, investors are willing to accept lower yields, making existing bonds with higher yields more attractive and driving up their prices.
Credit risk: Changes in interest rates can also affect credit risk, which refers to the risk that a borrower will default on their debt obligations. When interest rates rise, credit risk can increase, as borrowers may find it more difficult to make debt payments. This can lead to lower demand for bonds issued by companies with higher credit risk, potentially lowering their prices. Conversely, when interest rates fall, credit risk may decrease, making bonds issued by companies with higher credit risk more attractive to investors and potentially driving up their prices.
Duration risk: Changes in interest rates can also impact duration risk, which refers to the risk that the value of a bond will change due to changes in interest rates. Bonds with longer maturities are more sensitive to changes in interest rates than bonds with shorter maturities. This means that when interest rates rise, bonds with longer maturities can experience greater price declines, as they become less attractive to investors. Conversely, when interest rates fall, bonds with longer maturities can experience greater price increases, as they become more attractive to investors seeking higher yields.
Changing interest rates have significant impacts on all asset classes, but the effect it has on the bond market is very direct and profound. Any investor that holds bonds in their portfolio needs to understand this impact to ensure they can manage the risks effectively.
In next week’s article we will look at the impact changing interest rates have on the real estate market as well as the equity market.
