The Federal Reserve is finally acknowledging how entrenched inflation has become and it looks like it might actually take some serious steps to at least start to tackle it. Key among those steps is raising interest rates.
Interest rates have been on a downward trend for around 40 years, since the last time inflation shot up this high, making a rising rate environment something many investors haven’t experienced. The investment roadmap is a little different when interest rates are going up, so knowing how to invest when interest rates are going up is a skill that makes sense to learn. These five strategies can help you navigate what might otherwise be a tough patch in the market.
No. 1: Get your own balance under control
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Rising interest rates mean the cost of being in debt will rise. If you have variable-rate debt or debt that you’ll need to borrow more to pay off when it’s due, now is a good time to figure out how to pay it off or set a fixed rate for it. The more rates rise, the more expensive variable-rate debt becomes, and the more expensive it becomes to get new fixed-rate loans, too.
By paying off or refinancing your debt while rates are still fairly low, you can keep control of more of your income and cash flow. That’s an important part of being able to ensure you have money available to invest in the first place.
No. 2: Keep your bonus duration fairly short
If your financial allocation plan calls for you to own bonds, then in an environment of rising interest rates, you’ll want to make sure that the bonds you own are fairly short in duration. This is because the longer a bond’s duration, the more it will fall when interest rates rise.
If your intention is to hold your bonds until they mature, the cash flows from your bonds will not change just because interest rates rise. However, if you’re using your bonds as a drag on your portfolio or planning to sell them before maturity, recognize that bonds with low coupons and long terms to maturity can fall quite a bit as rates rise. Those are the types of bonds that generally have longer durations and therefore are more affected by rising interest rates.
No. 3: Keep an eye on your stock balances
The same risks that affect your ability to pay your debts when interest rates rise also affect the companies in which you invest. As rates rise, your variable-rate debt becomes more expensive immediately, and your fixed-rate debt becomes more expensive if you need to refinance it. as it matures.
This is important to recognize, as much corporate debt is structured as bonds where the company pays interest only until they are required to pay the principal in full when the debt matures. As a result, you’ll want to pay attention to both your debt levels and your debt maturity schedules, both of which are often noted in a company’s annual reports.
You’ll want to make sure the business continues to appear able to pay off its debt with its cash flow, even when those debts roll over at higher rates, requiring higher interest payments. If the debt market is concerned that a company can’t making those higher payments could force a business out of business by making it impossible for it to borrow new money. That kind of action could send your stock down to $0.
#4: Look for businesses with pricing power
As rates rise, companies with debt will generally see their margins squeezed by higher debt service costs. Those who have the ability to pass on those higher costs to their customers through higher prices are more likely to survive than those who don’t.
Given recent inflation, you may be able to gain insight into how strong a company’s pricing power is by listening to their earnings conference calls. If you hear comments like “volumes remained strong even as we priced to recover from commodity pressures,” then that’s a good sign that the company has at least some measure of pricing power.
No. 5: Focus on the value of the companies you own
Investors generally want to get the best risk-adjusted returns they can for the money they are putting at risk in the market. As interest rates rise, the potential future returns they can earn on lower-risk investments like bonds improve, making higher-risk investments like stocks much less attractive. That’s a key reason why the market has been falling recently, as the Federal Reserve talks about raising interest rates more aggressively.
Within that framework, companies that already seem fairly valued or downright cheap compared to their legitimate cash-generating potential may see much less of a downside as rates rise. After all, the cheaper a company’s value is, the more its market price depends on its proven results instead of his potential for rapid future growth. That makes it easier for investors to see a quick path to operating returns, which can help support those companies’ share prices.
With the Federal Reserve expected to raise interest rates by 50 basis points later this month to help fight inflation, the era of rising interest rates is very likely to come. That could make right now your last and best chance to kick-start your personal financial and investment plan to handle a higher rate environment. So get started now and stand a decent chance of beating these rising rates successfully.
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