Against a backdrop of strengthening economic growth, policymakers at the Bank of England are now widely expected to raise UK interest rates at some point during the first half of 2015.
So, after years of exceptionally low rates, what will a higher-rate environment mean for investors? Investors will often favour a pragmatic approach to the beginning of a rise in the interest rate cycle, preferring to concentrate on the positive reasons behind the increase. After all, after more than five years at their historic low of 0.5%, higher rates would imply confidence in a sustainable and growing economy.
For those inclined to rely relatively heavily on the income generated by their cash savings, higher interest rates are likely to come as a relief. On the other hand, an increase in the cost of borrowing will prove less welcome to those with debts, mortgage holders and buy-to-let investors, although commercial property could benefit from economic expansion.
Higher interest rates tend to be negative for bondholders because the rates paid by bonds are then seen as less competitive. That said, bonds are not a homogenous group and the reaction of government and investment-grade bonds is likely to differ from that of high-yield bonds, which are more closely correlated to the fortunes of the issuing companies.
The effect on shares is likely to vary. Although higher rates will drive up companies’ borrowing costs, this could be offset by stronger economic growth that is likely to prove positive for corporate earnings. However, higher interest rates will also provide a boost for the pound, which could have a negative effect on UK-based exporters once their profits are translated back into sterling. Meanwhile, shares in defensive companies that pay comparatively high dividends – for example, utility businesses – are viewed by some investors almost as a proxy for bonds, and are therefore less likely to benefit from an environment of rising rates. Conversely, so-called ‘cyclical’ companies, which tend to be relatively sensitive to the economic cycle, can perform better.
Ultimately, an increase in interest rates is likely to present both threats and opportunities so it is worth taking the time to review your assets and liabilities with your financial adviser and ensure your portfolio is positioned to make the most of a rising rate environment and sufficiently diversified to minimise the potential effects of market volatility on long-term performance.
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The value of your investment can go down as well as up and you may not get back as much as you originally invested.