Personal Finance
Key takeaways
- Regardless of inflation, it’s still best to base investments on your overall financial goals.
- Series I Bonds pay a fixed interest rate that is tied to the inflation rate when they are issued.
- Short-term bonds are less vulnerable to rising rates than long-term bonds.
It’s not always easy to know where to invest your hard-earned money. It can get especially tricky to make those financial decisions in the midst of an inflationary economy. When the Federal Reserve keeps trying to slow down the economy by raising interest rates, how do you know what to invest in?
As interest rates rise, the interest you pay on debt increases. But it also could mean higher interest rates on your deposits to savings accounts. And other investments may benefit, as well. So rising rates aren’t all bad, right?
In this article, we’ll try to help you make sense of the investment landscape. We’ll talk about some ideas to help you navigate market volatility and find investment opportunities in a rising rate environment.
Interest rates, inflation, and investing
The Federal Reserve manages the country’s money and money supply. It also manages its banking payment and transaction systems. It creates rules for these banks and other financial systems to follow. And it ensures that all products offered by these entities to consumers are fair and valid.
In addition to setting monetary policy, the Fed also sets interest rates. As the country’s economic conditions change, the Fed can raise or lower rates.
In 2022, the Fed raised rates several times in an attempt to battle inflation. It was trying to stem the elevated price of goods and services. Higher interest rates translate to higher borrowing costs. By raising interest rates, the Fed hopes to slow consumer spending. That could drive down demand for goods and services, and it would lower the inflation rate.
On the flip side, if the Fed lowers interest rates, it makes borrowing costs cheaper for consumers and businesses. This is generally done to rev up the economy by encouraging consumers and businesses to spend, invest, and borrow.
As you’ve probably guessed, these economy-shaking changes have a big impact on the stock market. They also affect your investment portfolio.
Typically, higher rates can create a negative impacton both stock market conditions and the bond market. Rate hikes can make borrowing money more expensive, which can impact the profitability of a business and its stock price. Higher costs can be passed on to the consumer in the form of higher prices for goods and services. But as consumers pay more to borrow money, they become less willing or able to absorb those higher prices. This chain reaction can take a toll on a business’s earnings and cash flow, which affect its stock price.
Where to put your money
It’s always important to consider your goals for your investments. But it’s best to err on the side of caution while chasing economic growth after a rate hike. Take extra time to consider what you want out of your investments. Consider your risk tolerance and when you might need access to the returns or principal. If you’re set to retire soon, you’ll have a different strategy than folks who have just begun their career.
Here’s a look at some general principles regarding investing when interest rates rise:
Series I savings bonds
These bonds are issued by the U.S. Treasury, and they’re referred to as I Bonds. Throughout these bonds’ life, they pay a fixed interest rate, a rate tied to rising inflation rates. These bonds cannot be redeemed until 12 months after their purchase date. If you cash out within 5 years, you’ll pay a penalty that is generally about 3 months’ worth of interest. There is also a cap on how much you can invest in I Bonds. No more than $10,000 per person can be invested during a calendar year.
Exchange-traded funds
An exchange-traded fund (ETF) is a pooled investment security that works much like a mutual fund. An ETF will generally follow a particular sector, commodity, index, or other asset class. Its share price will change throughout a trading day. These funds can contain many types of investments, including stocks, bonds, commodities, and a mixture of investment types.
Stock
Trading in stock for individual companies can be risky under any economic conditions because there’s no guarantee of future results. However, experts point to a few sectors that could benefit as rates rise. Those include banks and brokerage firms and companies with large cash reserves and solid past performance. Also, value stocks—stocks that are typically undervalued—can offer growth opportunities or pay dividends. Mutual funds can be a less risky way to invest in stocks.
Real estate
Higher rates will also mean higher mortgage rates, which of course means higher borrowing costs. But another option could be real estate investment funds. These funds pool investor money to collectively invest in real estate. They can offer the benefits of real estate investment without the challenges of being a direct owner, and less risk.
Short-term bonds
A preliminary warning: Trading in individual bonds can be a risky investment strategy. It’s best to talk with a financial professional who has expertise.
When it comes to the bond market, rising interest rates have an inverse relationship with bond prices. When interest rates rise, bond prices fall.Short-term bonds are less vulnerable to rising rates than long-term bonds with a maturity of 30 years. One important point to keep in mind is that higher-quality bonds are also more sensitive to rising interest rates.
Short-term bonds and floating-rate bonds could be a good fit for your financial picture. Many floating-rate funds invest in bank loans. Those bank loans have adjustable interest rates that change with other short-term rates. Because of this, floating-rate bonds are somewhat protected from price declines that can happen to bonds with fixed interest rates.
Many investors can mitigate some of the risk by investing in bond-oriented mutual funds and in exchange traded funds.
Pay down debt
Raised interest rates also mean that the variable interest rates on your outstanding balances will increase. Paying down that type of debt is a smart move when interest rates begin to climb. Personal loans that lock in lower, fixed rates or 0-percent interest balance transfer credit cards are good tools. When you use them to move your debt around, you could save a little money.
This article is for educational purposes only and is not intended to provide financial, tax or legal advice. You should consult a professional for specific advice. Best Egg is not responsible for the information contained in third-party sites cited or hyperlinked in this article. Best Egg is not responsible for, and does not provide or endorse third party products, services or other third-party content.