Tag Archives: Interest Rates

If Interest Rates Go Up, Do Stocks Go Down?

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I found a recent study conducted by Dimensional Fund Advisors, a synopsis of which is below, very interesting and timely given the rising interest rate environment.  For a background on bonds, I have also created a blog post today about How Bonds Work.

Should stock investors worry about changes in interest rates?

Research shows that, like stock prices, changes in interest rates and bond prices are largely unpredictable.[1] It follows that an investment strategy based upon attempting to exploit these sorts of changes isn’t likely to be a fruitful endeavor. Despite the unpredictable nature of interest rate changes, investors may still be curious about what might happen to stocks if interest rates go up.

Unlike bond prices, which tend to go down when yields go up, stock prices might rise or fall with changes in interest rates. For stocks, it can go either way because a stock’s price depends on both future cash flows to investors and the discount rate they apply to those expected cash flows. When interest rates rise, the discount rate may increase, which in turn could cause the price of the stock to fall. However, it is also possible that when interest rates change, expectations about future cash flows expected from holding a stock also change. So, if theory doesn’t tell us what the overall effect should be, the next question is what does the data say?

Recent Research

Recent research performed by Dimensional Fund Advisors helps provide insight into this question.[2] The research examines the correlation between monthly US stock returns and changes in interest rates.[3] While there is a lot of noise in stock returns and no clear pattern, not much of that variation appears to be related to changes in the effective federal funds rate.[4]

For example, in months when the federal funds rate rose, stock returns were as low as –15.56% and as high as 14.27%. In months when rates fell, returns ranged from –22.41% to 16.52%. Given that there are many other interest rates besides just the federal funds rate, Dai also examined longer-term interest rates and found similar results.

So to address our initial question: when rates go up, do stock prices go down? The answer is yes, but only about 40% of the time. In the remaining 60% of months, stock returns were positive. This split between positive and negative returns was about the same when examining all months, not just those in which rates went up. In other words, there is not a clear link between stock returns and interest rate changes.

Conclusion

There’s no evidence that investors can reliably predict changes in interest rates. Even with perfect knowledge of what will happen with future interest rate changes, this information provides little guidance about subsequent stock returns. Instead, staying invested and avoiding the temptation to make changes based on short-term predictions may increase the likelihood of consistently capturing what the stock market has to offer.

Glossary of Terms

Discount Rate: Also known as the “required rate of return,” this is the expected return investors demand for holding a stock.

Correlation: A statistical measure that indicates the extent to which two variables are related or move together. Correlation is positive when two variables tend to move in the same direction and negative when they tend to move in opposite directions.

Index Descriptions
Fama/French Total US Market Index: Provided by Fama/French from CRSP securities data. Includes all US operating companies trading on the NYSE, AMEX, or Nasdaq NMS. Excludes ADRs, investment companies, tracking stocks, non-US incorporated companies, closed-end funds, certificates, shares of beneficial interests, and Berkshire Hathaway Inc. (Permco 540).

 

[1]. See, for example, Fama 1976, Fama 1984, Fama and Bliss 1987, Campbell and Shiller 1991, and Duffee 2002.

[2]. Wei Dai, “Interest Rates and Equity Returns” (Dimensional Fund Advisors, April 2017).

[3]. US stock market defined as Fama/French Total US Market Index.

[4]. The federal funds rate is the interest rate at which depository institutions lend funds maintained at the Federal Reserve to another depository institution overnight.

 

Source: Dimensional Fund Advisors LP.

Results shown during periods prior to each Index’s index inception date do not represent actual returns of the respective index. Other periods selected may have different results, including losses. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains.

Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.

There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

 

Bonds: How do they work

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Investing in Bonds

Bonds may not be as glamorous as stocks or commodities, but they are a significant component of most investment portfolios. Bonds are traded in huge volumes every day, but their full usefulness is often underappreciated and underestimated.

Why invest in bonds?

Bonds can help diversify your investment portfolio. Interest payments from bonds can act as a hedge against the relative volatility of stocks, real estate, or precious metals. Those interest payments also can provide you with a steady stream of income.  Additionally, because individual bonds have a face value and maturity date, investors like knowing how much and when to expect their investment.

Bonds as Part of Your Overall Portfolio Strategy

Bonds play an important role in your overall portfolio strategy, AKA investment mix.  As interest rates rise and bond prices are impacted, your overall portfolio allocation will be impacted as well.

For those of you who are managing a portfolio on your own and read this blog for education, or are hourly/project based clients, that will mean that you will need to monitor your portfolio and rebalance the allocation back to your original allocation/investment mix.  If you do not, then the amount of risk/projected return in the portfolio will not match the amount of risk/return you wanted in the portfolio.

For those of you who work with us on an ongoing basis for investment management/partnership based clients, we set up “target bands” according to your allocation/investment mix and make changes when your portfolio deviates from those bands.  So we do not wait until a certain time of year, we make changes as needed and only if needed.

I wrote earlier about the importance of rebalancing a portfolio and how rebalancing works.

How bonds work

When you buy a bond, you are essentially loaning money to a bond issuer in need of cash to finance a venture or fund a program, such as a corporation or government agency. In return for your investment, you receive interest payments at regular intervals, usually based on a fixed annual rate (coupon rate). You are also paid the bond’s full face amount at its stated maturity date.

You can purchase bonds in denominations as low as $100, and often in increments of $1,000 (though individual brokers may have a higher minimum purchase). Some are backed by tangible assets, such as mortgage contracts, buildings, or equipment. In many other cases, you simply rely on the issuer’s ability to pay. You can buy or sell bonds in the open market in the same manner as stocks and other securities. Therefore, bonds fluctuate in price, selling at a premium (above) or discount (below) to the face value (par value). Generally, the longer a bond’s duration to maturity, the more volatile its price swings. These factors expose bonds to certain inherent risks.

You can buy or sell bonds in the open market in the same manner as stocks and other securities. Therefore, bonds fluctuate in price, selling at a premium (above) or discount (below) to the face value (par value). Generally, the longer a bond’s duration to maturity, the more volatile its price swings. These factors expose bonds to certain inherent risks.

Bond risk factors

Although many bonds are conservative, lower-risk investments, some others are not, and all carry some risk. Because bonds are traded in the securities markets, there is always the chance that your bonds can lose favor and drop in price due to market risk; as a result, a bond redeemed prior to maturity may be worth more or less than its original cost. Much of this volatility in price is tied to interest-rate fluctuations. For example, if you pay $1,000 for a 5 percent bond, that same $1,000 might buy you a 6 percent bond the following month, if interest rates rise. Consequently, your old 5 percent bond may be worth less than $1,000 to current investors.

Since bonds typically pay a fixed rate of interest, they are open to inflation risk. As consumer prices generally rise, the purchasing power of all fixed investments is reduced. Also, there is a chance that the issuer will be unable to make its interest payments or to repay its bonds’ face value at maturity. This is known as credit or financial risk. To help minimize this risk, compare the relative strength of companies or bonds through a ratings service such as Moody’s, Standard & Poor’s, A. M. Best, or Fitch. Finally, bonds also involve reinvestment risk: the risk that when a bond matures, you may not be able to get the same return when you reinvest that money.

Corporate bonds

Bonds issued by private corporations vary in risk from typically steady utility bonds to highly volatile, high-interest junk bonds. Also, many corporate bonds are callable, meaning that the debt can be paid off by the issuing company and redeemed on a predeterminded fixed date. The company pays back your principal along with accrued interest, plus an additional amount for calling the bond before maturity.

Some corporate bonds are convertible and can be exchanged for shares of the company’s stock on a fixed date. You can also purchase zero-coupon bonds, which are issued at a discount to (below) face value. No interest is paid, but at

You can also purchase zero-coupon bonds, which are issued at a discount to (below) face value. No interest is paid, but at maturity you receive the face value of the bond. For example, you pay $600 for a 5-year, $1,000 zero-coupon bond. At the end of 5 years, you receive $1,000. Corporate bonds have maturity dates ranging from one day to 40 years or more and

Corporate bonds have maturity dates ranging from one day to 40 years or more and generally make fixed interest payments every six months.

U.S. government securities

The securities backed by the full faith and credit of the U.S. government carry minimal risk. United States Treasury bills (T-bills) are issued for terms from a few days to 52 weeks. They are sold at a discount and are redeemed

United States Treasury bills (T-bills) are issued for terms from a few days to 52 weeks. They are sold at a discount and are redeemed for their full face value at maturity. Other Treasury securities include Treasury notes, which have terms from 2 to 10 years, Treasury Inflation Protected Securities (TIPS), which have terms from 5 to 30 years, and Treasury bonds, which have a term of 30 years. Although the interest earned on these securities is subject to federal taxation, it is not subject to state or local taxes.

Other Treasury securities include Treasury notes, which have terms from 2 to 10 years, Treasury Inflation Protected Securities (TIPS), which have terms from 5 to 30 years, and Treasury bonds, which have a term of 30 years. Although the interest earned on these securities is subject to federal taxation, it is not subject to state or local taxes.

Various federal agencies also issue bonds. As with any investment, these bonds carry some risk. However, because the U.S. government guarantees timely payment of principal and interest on them, they are considered very safe. Some of these bonds use mortgages as collateral. Most mortgage-backed securities pay monthly interest to bondholders.

Municipal bonds

Municipal bonds (munis) are issued by states, counties, or municipalities, and are generally free from federal taxation (with some exceptions). Some may be completely tax free if you are a resident of the state, county, or municipality of issuance. Though municipal bonds generally offer lower interest payments compared with taxable bonds, their overall return may be higher because of their tax-reduced (or tax-free) status. Some municipal bond interest also could be subject to the alternative minimum tax. You must select bonds carefully to ensure

Though municipal bonds generally offer lower interest payments compared with taxable bonds, their overall return may be higher because of their tax-reduced (or tax-free) status. Some municipal bond interest also could be subject to the alternative minimum tax. You must select bonds carefully to ensure

You must select bonds carefully to ensure a worthwhile tax savings. Because municipal bonds tend to have lower yields than other bonds, the tax benefits tend to accrue to individuals with the highest tax burden.

Munis come in two types: general obligation (GO) bonds and revenue bonds. GO bonds are backed by the taxing authority of the issuing state or local government. For this reason, they are considered less risky but have a lower coupon rate. Revenue bonds are supported by money raised from the bridge, toll road, or other facility that the bonds were issued to fund. They pay a higher interest rate and are considered riskier. Therefore, research the project being funded to the extent possible before you invest, to make sure that it will generate sufficient income to make payments.

Monitoring your bond portfolio

Of course, you’ll want to keep an eye on your bond portfolio, as you should with all of your investments. Although other factors may affect them, bond prices are often closely tied to interest rates. When rates go up, the market price of your bonds tend to go down; when interest rates fall, your bonds generally rise in value.

Interest rates also tend to affect a bond’s current yield, which measures the coupon rate of your bond in relation to its current price. The current yield rises with a corresponding drop in the price of a bond, and vice versa. In addition, inflation, corporate finances, and government fiscal policy can affect bond prices.

The major bond-rating services offer letter grades regarding the relative strength of a corporation or bond.  Your brokerage statement or brokerage account website will often have the credit rating for your bonds.  Keep an eye on the credit rating to make sure that it is still in investment grade range which for Standard and Poor’s is BBB- or higher and Moody’s is Baa3 or higher.

Portions of this blog post are from an article prepared by Broadridge Investor Communications Solutions, Inc. Copyright 2017  But, I just had to add my own two cents!