Many investors understand that, as interest rates increase, borrowing becomes more costly and can cause individuals to seek safer investments that still provide decent returns. Lower interest rates encourage consumer spending and business stock investment, leading to greater company profits and eventually higher stock prices.
1. Fixed-Income Investments
Fixed income investments like bonds and preferred stocks provide regular, steady streams of income over an extended period. They are an integral component of most investment portfolios because they add extra stability in times of stock market turmoil while helping reduce overall portfolio volatility.
Bonds come in various varieties, but most are considered less risky than stocks. Government bonds (also called Treasuries) may even be risk-free since they’re backed by national currency and so don’t pose as much of a threat to investors’ money. Bond and fixed-income securities prices may decline when interest rates increase due to how rising interest rates lower bond prices by effectively decreasing expected future yield.
2. Commodities
Regardless of your journey, it’s likely that you’ve encountered commodity markets either directly or indirectly. These markets contain raw materials such as grains, precious metals, and energy resources used in everything from the cereal you consume every morning to car fuel or gold jewelry.
As an investment category, commodities generally exhibit low or negative correlations to stocks and bonds, making them an effective asset class to diversify your holdings or hedge against inflation. Interest rate changes may have an effect on commodity investments as higher rates make borrowing money more costly for businesses and reduce bond values, in turn increasing commodity prices.
3. Stocks
Stocks (or equities) are shares of ownership in a publicly traded company that are traded on an exchange. Through this method, companies can sell shares to raise capital for business expansion or other purposes, while investors purchase these shares in the hopes of appreciation and potential profit.
Stocks are considered risky investments due to their potential for both losses and gains. Investors should diversify their portfolio according to investment style, size (market capitalization), sector, and geographical region, also allocating some growth and value stocks as part of their allocation strategy. Younger investors with longer investment timelines are freer to take more risks with their stocks, while those saving for retirement should allocate a smaller percentage toward stocks while increasing bonds or more conservative assets as an asset class.
4. Bonds
Bonds may be ideal if your primary investment objective is principal preservation. Bonds generally provide regular returns of principal plus interest payments until their scheduled maturity date, providing you with security in case anything goes awry with your initial investment.
As interest rates increase, bond prices typically decline as higher-yielding bonds enter the market; however, their exact relationship can depend on your personal financial goals, risk tolerance, and time horizon. Bonds generally represent lower risk than stocks and provide an essential part of a diversified portfolio. But as any asset can fluctuate over time, it’s essential that you consider your goals, risk tolerance, and time horizon before making changes to your bond allocation.
5. Money Markets
Before the 2008 financial crisis, money markets were often taken for granted as reliable and low-volatility segments of the finance system. They provided investors a way to park funds while offering short-term cash infusions for banks, brokers, hedge funds, and nonfinancial corporations alike.
Rising rates increase the cost of borrowing, which in turn can hinder business profits and decrease consumer spending, leading to less spending by consumers—potentially driving shares down in sectors sensitive to interest rates like real estate or finance. Rate decreases reduce borrowing costs and can facilitate investment and spur stock price appreciation, but they can also create volatility as investors sell off stocks in anticipation of higher rates. During the COVID-19 pandemic, many money market funds experienced a decline in value, with their net asset values falling below $1 per share.
6. Short-Term Investments
Long-term investing goals often demand higher returns and greater market risk, so those seeking lower risks may prefer shorter-term investment options such as CDs, money market accounts, high-yield savings accounts, or short-term bond funds. These investments offer liquidity and financial flexibility. Investors can quickly withdraw funds if necessary without being as affected by market volatility.
Short-term investors typically look for investments with shorter holding times to save for specific financial goals, like an emergency fund or down payment on a car. Lower returns often come at the price of security and peace of mind for these investors who often hold onto assets for only several years; diversifying across multiple asset classes like stocks, bonds, and commodities provides further protection.
7. Other Assets
As interest rates increase, stock prices typically decline due to their correlation with future profits and cash flows: when interest rates go up, investors value future earnings less highly and accordingly expect their investments to suffer accordingly.
Rising interest rates can make borrowing money more costly for companies and make bonds more appealing, decreasing profit margins. Financial stocks like banks and insurance companies may benefit from rising rates because they can charge higher loan interest rates; current assets like accounts receivable, inventory, prepaid expenses, and short-term investments typically convert to cash within one or two years and earn low stable returns that don’t keep pace with inflation, though investing in such assets does come with its share of risks.