Understanding Interest Rates: What They Are, Why They Matter, and How They Can Affect Your Portfolio

Summer 2010 CSANews Issue 75  |  Posted date : Jul 20, 2010.Back to list

There's been a lot of talk about interest rates lately. Many economists, analysts and market pundits have commented at length about whether rates will rise, fall, or stay the same in the coming months.

What does it all mean? What do interest rates measure, anyway? What happens to the economy - or your portfolio - when they go up or go down? Why are so many people paying attention to them right now?

Here are some answers to those questions, along with some helpful tips on how you can respond to interest rates, should they rise in the near future.

Interest Rate Basics

Essentially, interest rates measure the price of money - how much it would cost to "rent" money (i.e. take out a loan) for a given period of time, usually a year. Most of the time, we talk about interest rates by quoting the rate charged by the federal government (via the central bank) when it lends money to banks and other large financial institutions. This, in turn, forms the basis for the "prime rate" - the interest rate banks charge to their best customers.

There are many reasons why interest rates go up and down. For example, the federal government can lower rates to encourage economic growth; by making it cheap to borrow, the government hopes that companies and consumers will spend more which, in turn, will create more jobs. But for investors, the most important reason interest rates fluctuate is inflation - the annual increase or decrease in the price of consumer goods.

Inflation and Interest Rates

When inflation rises, interest rates usually follow suit. Why? Because banks, investors and consumers all want to safeguard the "purchasing power" of their money. That is, they want to ensure that their money is capable of buying the same amount of goods or services in the future as it does today.

Think of it this way: if you lent $1,000 to someone for a year (which is what you do when you buy a bond, a GIC or other fixed-income investment), you'd want all of it back. But what if the purchasing power of that $1,000 had diminished by the time your money was returned? Naturally, you'd want to protect yourself from this happening. Otherwise, there'd be no incentive to lend - you'd be better off spending the money today, rather than a year from now, when it won't buy as much.

And that's a very simplified explanation of why interest rates rise. When it looks like gasoline, groceries and basic consumer goods will cost more in a year or two than they do now, lenders want to be compensated for that risk. So they charge more interest, hoping that this will make up for the diminished purchasing power of their money when they're eventually repaid.

What happens next?

Unfortunately, it's next to impossible to predict where rates are going with 100% accuracy. That said, by looking at some important economic fundamentals, we can make some broad predictions about what will happen to interest rates in the months ahead.

As the developed world suffered through the worst recession in more than 80 years, governments in North America and Europe lowered interest rates to rock-bottom levels in order to stimulate corporate and consumer spending. Obviously, there's not much lower that rates can go. Sooner or later, as economic growth starts to pick up, interest rates will rise.

Currently, Canada's economic fundamentals continue to look much better than many other developed economies (particularly the United States). While unemployment remains high, companies are spending again and the economy has started expanding again. At the start of June, the Bank of Canada officially ended its ultra-low interest rate policy by raising its trend-setting interest rate by 0.25%. But it was cautious on the subject of further rate hikes: given the considerable economic uncertainty that remains, the Bank is likely to take a slow-and-steady approach to further rate hikes.

What to Do About Rising Rates

While there is nothing that you can do to stop interest rates from rising, you can take steps to defend yourself from the impact which rising rates will have on your finances. Here are some simple ideas:
  • Pay off debt
One easy way to protect yourself from rising interest rates is to pay down debt. Even a small uptick in the rate which you're charged on a loan can dramatically affect the amount of principal you pay off with every payment. That can add months or even years of additional payments to your existing loan. High-interest debt such as credit cards should be your first priority here; a home-equity line of credit is another important priority. The interest on such loans usually rises in tandem with the bank's prime rate increases. If you're not careful, your minimum payment can rise dramatically in a very short time.
  • Think About Locking In Your Mortgage
Because mortgage rates are closely related to the rise in interest rates (though not exactly), we could be looking at the end of cheap mortgage financing for some time to come. This means that now could be an excellent time to lock in a mortgage at today's historically low rates, particularly if you've been enjoying a variable-rate mortgage whose interest rate fluctuates with the prime lending rate. Most homeowners with variable-rate mortgages can easily switch into a fixed-rate mortgage with little or no penalty.

For homeowners looking to refinance an existing closed mortgage, the calculation gets a little more complicated. Generally speaking, the earlier you are in your term, the more advantageous it is to refinance. But this is only a generalization - you'll want to crunch the numbers yourself to make sure that a refinancing makes sense, given your personal financial circumstances.
  • Be Cautious With Bonds
If a portion of your portfolio is invested in bonds, you'll want to watch interest rates closely over the coming months. The value of bonds can fluctuate significantly when interest rates rise and fall; this is particularly the case with long-term bonds. Savvy investors can profit a great deal from these moves, but it takes knowledge, discipline and a good deal of luck. All in all, a game best left to professionals.

Probably the best way to protect a bond portfolio from interest rate fluctuations is to "ladder" it. Divide your portfolio into a series of one, two, three, four and five-year bonds. When the one-year bonds mature, reinvest the capital into new five-year bonds, which will likely be paying higher interest rates. Repeat the process regularly (usually annually), whenever the shortest-duration bonds mature. With such a strategy, interest rates will still have an effect on the overall value of your bond portfolio, but those effects will be much more muted.
  • Diversify your equity portfolio
Rising interest rates aren't always a bad thing. In fact, some companies tend to
perform well in times of rising interest rates - consumer staples stocks, for example. Others, such as banks and utilities, are much more sensitive to interest rate fluctuations: they tend to go down when rates go up, and vice versa. And then there are companies that aren't affected much by interest rates at all - health-care and drug companies would be examples here.

Much like with bonds, professionals can profit by investing in particular companies or sectors of the economy that are expected to perform well in a rising- or falling-rate environment. But again, this kind of trading takes a good deal of detailed financial knowledge. For the average investor, diversifying the portfolio among several sectors of the economy and balancing out the effect of rising rates is usually a much more effective strategy.

No one knows for sure when interest rates will start their slow climb from their current lows. When it happens, however, the effect could be dramatic. Take steps now to prepare yourself. Your portfolio will thank you for it.