Where to invest in a rising interest rate economic environment

What effect does rising interest rates have on a company’s share price?

If interest rates rise and a company has debt, servicing that debt will be more expensive. Assuming that sales and expenses remain similar to the previous financial year, the company’s profit will decline. If its profit falls, its value or share price will correspondingly decrease.

Hence, the companies most at risk of declining profitability and share price are companies with significant debt on their balance sheet.

Companies with significant debt and low profitability, making a loss, are at the most significant risk of experiencing a declining share price. (This is akin to a couple having a very large home mortgage. If the couple is both working and have secure jobs and are on high salaries, their ability to service the debt will undoubtedly be more challenging as interest rates rise, but they will manage. However, a couple where only one partner is working, and the working party is on a modest income may find it impossible to manage the same degree of debt if interest rates rise.)

Generally speaking, many technology-style companies, research and development companies, exploration companies, and small start-ups have higher debt and modest profits. These companies are likely to experience cash flow pressure as interest rates rise.

What to consider

With higher interest rates, there is an opportunity for companies such as banks and insurance companies to improve their profit margins. However, if interest rates increase at a greater rate than real wages growth, then there may be a corresponding increase in the degree and frequency of home loan defaults.

What to avoid

It is prudent to be underweight in stocks such as discretionary retailers in a rising interest rate environment. The theory is that as interest rates rise, people will have higher mortgage expenses, and everyday living costs will increase, so the remainder available for discretionary spending will be correspondingly reduced. This, in turn, will affect the sales and profitability of discretionary spending retailers.

Be careful of your exposure to fixed interest, particularly longer-dated bonds, that is, bonds that mature in five years or more. Generally, higher or rising interest rates translate to a reduction in bond valuation. If you do have exposure to fixed interest, seek shorter-term bonds.

Should you require further information in relation to investing, please feel free to contact Peter Quinn by submitting an enquiry or calling us on +61 2 9580 9166 to book an obligation free appointment.

The information in this document does not take into account your personal objectives, financial situation or needs, and so you should consider its appropriateness having regard to these factors before acting on it.  It is important that your personal circumstances are taken into account before making any financial decision and it is recommended that you seek assistance from your financial adviser.