The Federal Reserve has all but guaranteed us that interest rate increases will be forthcoming, perhaps as soon as March of this year. Further, the process of quantitative easing, or increasing the money supply as the Fed buys government bonds, will be dialed back to zero. We know that interest rate increases should have an impact on the value of fixed income securities that a private investor would be currently holding. But what about private investors who have income-based equity sections in their portfolios. Will they have to watch out for declining values as well?
Fixed rate investments: As interest rates go up, the first step is an increase in the rate for Fed Funds, or the rate the Federal Reserve charges to banks for loans. This is where money markets will begin to feel the effect of increasing rates, as commercial bank interest rates of all varieties begin to climb. Since many corporations need to borrow often, money will become tighter in the money markets, and the coupon rates offered by corporations on bonds, notes, and other fixed instruments will also begin to climb. This could translate into a decline in the current value of investors’ bonds as bond buyers will look to obtain higher coupon rates. But as the higher coupon rates begin to hit the marketplace, eventually yields will rise for current bond investors, too. They will need to rotate money out of the lower yielding bonds or stocks and look for buys of newer, higher interest-bearing issues. Savers will also benefit from higher rates paid for savings accounts.
The QE effect: The process of quantitative easing keeps feeding money into the markets, as the Fed becomes a buyer of U.S. Government Bonds. This process is due to stop in March just as the interest rates begin to rise. What QE does is to keep a tremendous amount of liquidity flowing into the money markets that in turn keeps interest rates low for corporate borrowers. When QE stops flowing, this plethora of liquidity will dry up, and corporate borrowers will need to pay higher interest for the available funds. Further, if inflation doesn’t cool off in a reasonable amount of time, the Fed may need to reverse the QE process by selling the bonds back into the marketplace and taking the cash out, thereby reducing the money supply.
Impact on equity investments: Will rising interest rates have an impact on stock investments? A large number of stocks pay dividends that amount to a yield that the private investor receives similar to interest paid to bond holders. The difference is that dividends are paid out of the profits that the corporation makes. These profits can be impacted by rising interest costs as the net income would be reduced, all things being equal. Reduced net income also would mean a reduction of the amount sent to retained earnings, the reserve account from which dividends are paid. In general, there would be less left over for the shareholders. However, corporate managers are usually careful to forecast foreseeable changes to interest rates and price these changes into their dividend decisions. But the private investor should beware that if the dividend is reduced, the value of the corresponding stock most likely would be also be reduced. To determine the stock’s valuation, the net revenue stream is very often estimated for perhaps the next ten years and then discounted back to the current point in time. Changes to the revenue stream owing to interest rate changes could translate back to changes in this valuation. In any case, a reduction in the dividend will most likely force major shareholders to sell, thereby driving down the stock’s price.
Impact on MLP’s, BDC’s and REIT’s: Master Limited Partnerships, Business Development Corporations, and Real Estate Investment Trusts are equity investments that translate a large portion of the firm’s net income into dividends to shareholders. In that respect, the dividends act as a substitute for bond interest payments to the investor as they are all but guaranteed. But as business goes, hard times can set in with higher interest costs, reduced revenues, and pressure to reduce the dividends thereby pressuring the valuation of the MLP, BDC, or REIT. Business Development Corporations in particular face declining values when interest rates increase, as their business models have them borrowing in money markets and lending to corporate entities that cannot borrow in the money markets themselves or would have to pay exorbitantly to do so.
Preferred stocks: Preferred stock acts as something of a hybrid security in that it pays dividends at a preset rate similar to bonds, but the returns are not guaranteed, and the holder does not have the same rights as bondholders at liquidation. The preferred dividends must be paid up to date before any funds can be made available by the company to common shareholders. Some preferred stocks have covenants that make them behave almost like a bond. The preferred dividend is often scored by brokers as bond interest. Rising interest rates would then have a similar impact on preferred shares as it would on other fixed instruments.
Conclusion: Those companies with high amounts of debt will suffer the most from interest rate increases as they will be faced with higher borrowing costs before they will be able to radically reduce excessively high debt. Private investors can check the fundamentals of their holdings by looking at the entity’s balance sheet and dividing long-term debt by total equity. If this ratio becomes higher than 3-1, the impact of borrowing costs could begin to affect valuations. For fixed investors, patience is the key, as better fixed yields will be coming soon. The value of existing bond investments may decline, however, but decisions should be made on a case-by-case basis if the bonds should be sold and the proceeds moved into newer, higher paying, bond issues. And finally, the Fed’s process of tightening is not a short-term phenomenon. The tightening cycle could go on for several years before slowing up, and then take several more years before it returns to today’s levels.