Since the Fed released their December FOMC meeting notes, there has been a lot of chatter about interest rates recently. They indicated in their notes that in order to battle inflation, rates may have to be raised sooner than expected. Some experts predict up to three rate hikes this year, with many expecting one as early as March. What does this mean for the markets, specifically stocks and bonds, as well as your portfolio? I will explain.

Let us start with bonds. The price of a bond and its yield are inversely correlated. Therefore, as interest rates rise, bond prices decline. The good news is that even if the bond’s price drops, it will be compensated by higher-income payments in the long run; that is, the possibility of purchasing new bonds with higher yields or reinvesting money received from maturing bonds into new bonds with higher yields, increasing your holding period return. As a result, the risks of losing a lot of money in less volatile bonds are substantially smaller than in stocks. Not to mention the diversification benefit bonds offer in your overall portfolio.

Next, stocks. I must first explain how interest rates affect the cost of capital before explaining how interest rates affect stocks. The relationship between interest rates and the cost of borrowing money is straightforward. When you borrow money, you must pay interest to the lender. That is the cost of borrowing money from a bank or other financial institution. When interest rates rise, you will have to pay more in interest, bringing your total cost of capital up. Conversely, if interest rates fall, you will pay less for debt. What does this have to do with stocks?

Borrowing becomes more expensive for both consumers and businesses as interest rates rise. This can reduce company profit margins and make stocks less appealing to investors, while also lowering consumer demand because people will have less disposable income to spend if their mortgage and other loan payments increase. This tends to lower stock market valuations and lower demand over time, which helps to bring inflation under control. As a result of the rising cost of capital, growth companies can become less enticing to investors, as they are more likely to take on debt because they might not have strong margins, consistent cash flows, or are still in the growth stage cycle. During this period, value stocks are more advantageous. Value companies can be preferable in higher interest rate settings since they do not require debt repayment because they have all the attributes that growth stocks lack.

Should you be concerned now that you understand how interest rates affect your portfolio? The answer is that, while higher interest rates have certain drawbacks, they also have advantages. As long as you have a well thought out strategy for your portfolio, you should have nothing to fear. There may be some bumps in the road along the way, as we have seen with the markets moving up and down every day since the beginning of the year. But remember, as my colleague Kenny Wolin said in last week’s piece, keep your emotions out of it. Trust that you will make it through, and those things are not as awful as they seem. After all, historically, the stock market tends only to go up in the long run.

– Andrew Ochoa

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