Three ways higher interest rates can affect your investments

You’d have to have been living under a rock for the past year to not know that interest rates have been on the rise as central banks around the world endeavour to return rates to normal levels, following sharp cuts through the pandemic.

Normalising rates is not without pain, however, as many who bought homes two or three years ago are very well aware right now. But higher interest rates can affect investors too.

Higher interest rates have impacts on investors too.Credit: Bloomberg

The most direct way that higher interest rates impact your share portfolio is the effect they have on borrowing costs. Higher interest rates mean that both businesses and individuals must spend more of their available cash servicing debt. Cash that they now have to pay out as interest cannot be used to hire additional staff, invest in new machinery or office space, a new marketing campaign, or some other growth initiative.

At the individual level, more money going out the door in mortgage repayments means less money available to spend on cafes, restaurants, clothes, and all the other discretionary things that make us happy.

For both businesses and individuals, higher interest rates reduce economic activity. In an environment of reduced economic activity, it’s reasonable to expect most companies listed on the stock market to face challenges in growing their profits.

In some cases, profits might decline, and potentially in extreme cases, profits might evaporate entirely. Therefore, higher interest rates impact your share portfolio by reducing the profits of the businesses that you own.

The second way higher interest rates impact your share investments is that they reduce the attractiveness for investors to borrow to invest. Borrowing to invest in property is quite unremarkable and rarely given much thought. Borrowing to invest in shares is not as easy, but it’s still reasonably common, especially for high-income earners looking to accelerate their wealth creation.

When the cost of money was two or three per cent, borrowing and investing in shares was a pretty easy play. Looking at Australian shares at least, the dividends alone were typically enough to cover the interest expense. But with the rapid rise in interest rates that we’ve seen, that gets tougher.

The third way that higher interest rates impact your share portfolio is by providing investors with more alternatives. Until recently, it was hard to make the case to have significant portions of wealth in low-risk, defensive-type assets. The returns were just so low that these investments didn’t make any sense.

You were better off buying low-risk Australian shares and collecting the dividend. In this low interest rate world, the share market drew in some investors’ savings that would perhaps ordinarily not be in the market.

As rates rise, that tide is turning. Term deposit rates of 4 per cent plus mean that some investors are backing out of share market investments and returning to the defensive investments that are their preference. Even bonds, which have had a horrendous 18 months, now look to be quite reasonably priced, providing another alternative for those investors seeking greater stability.

Share prices are a function of supply and demand. Whenever you buy a share, someone else must be selling it. When there are more buyers than sellers, prices go up, and of course, the reverse also applies. During the extreme low interest rate period through the pandemic, share markets were like a magnet for investors’ savings.

But now we’re on the other side of that journey, the magnetic pull has switched back to low-risk investments for some investors, creating an environment of increased sellers, with its natural tendency to depress prices.

• Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.

Paul Benson is a Certified Financial Planner, and host of the Financial Autonomy podcast.

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