Threats of Interest Rate Risk in Stock Investments - dummies

Threats of Interest Rate Risk in Stock Investments

By Paul Mladjenovic

Historically, rising interest rates have had an adverse effect on stock prices and investments. Because the United States country is top-heavy in debt, rising interest rates are an obvious risk that threatens both stocks and fixed-income securities.

Interest rate risk can hurt a company’s financial condition

Rising interest rates have a negative impact on companies that carry a large current debt load or that need to take on more debt, because when interest rates rise, the cost of borrowing money rises, too. Ultimately, the company’s profitability and ability to grow are reduced. When a company’s profits (or earnings) drop, its stock becomes less desirable, and its stock price falls.

Interest rate risk can affect a company’s customers

A company’s success comes from selling its products or services. But what happens if increased interest rates negatively impact its customers (specifically, other companies that buy from it)? The financial health of its customers directly affects the company’s ability to grow sales and earnings.

Consider Home Depot during 2005–2008. The company had soaring sales and earnings during 2005 and into early 2006 as the housing boom hit its high point (record sales, construction, and so on). As the housing bubble popped and the housing and construction industries went into an agonizing decline, the fortunes of Home Depot followed suit because its success is directly tied to home building, repair, and improvement.

The point to keep in mind is that because Home Depot’s fortunes are tied to the housing industry, and this industry is very sensitive and vulnerable to rising interest rates, in an indirect — but significant — way, Home Depot is also vulnerable.

Interest rate risk can impact investors’ decision-making considerations

When interest rates rise, investors start to rethink their investment strategies, resulting in one of two outcomes:

  • Investors may sell any shares in interest-sensitive stocks that they hold. Interest-sensitive industries include electric utilities, real estate, and the financial sector. Keep in mind that interest rate changes affect some industries more than others.

  • Investors who favor increased current income (versus waiting for the investment to grow in value to sell for a gain later on) are definitely attracted to investment vehicles that offer a higher yield. Higher interest rates can cause investors to switch from stocks to bonds or bank certificates of deposit.

Interest rate risk can hurt stock prices indirectly

High or rising interest rates can have a negative impact on any investor’s total financial picture. When an investor struggles with burdensome debt, he may sell some stock to pay off some of his high-interest debt. Selling stock to service debt is a common practice that, when taken collectively, can hurt stock prices.

Recently, the stock market and the U.S. economy faced perhaps the greatest challenge since the Great Depression — a powerful recession mired in stagnation and lots of debt. In terms of gross domestic product (GDP), the size of the economy was about $14 trillion (give or take $100 billion), but the debt level was more than $50 trillion (this amount includes personal, corporate, mortgage, college, and government debt).

This already enormous amount doesn’t include more than $70 trillion of liabilities such as Social Security and Medicare. Additionally, some of our financial institutions hold more than 500 trillion dollars’ worth of derivatives. These can be very complicated investment vehicles that can backfire. Derivatives have, in fact, sunk some large organizations (such as Enron and Bear Stearns), and investors should be aware of them.

Because of the effects of interest rates on stock portfolios, both direct and indirect, successful investors regularly monitor interest rates in both the general economy and in their personal situations. Although stocks have proven to be a superior long-term investment, every investor should maintain a balanced portfolio that includes other investment vehicles.

A diversified investor has some money in vehicles that do well when interest rates rise. These vehicles include money market funds, U.S. savings bonds (series I), and other variable-rate investments whose interest rates rise when market rates rise. These types of investments add a measure of safety from interest rate risk to your stock portfolio.