Rising rates

Is it time to start thinking about higher interest rates? Slowly but surely, the Bank of England’s Monetary Policy Committee appears to be moving towards raising rates, with more members of the MPC having voted in favour in recent months. The Bank’s Governor, Mark Carney, is now talking up the prospects for the UK economy, which will make it easier to raise rates. And the economic data, particularly from the all-important services sector, looks stronger too, adding to the clamour for an increase in rates.

For many investors, this will be unfamiliar ground. Although we did have one interest rate increase last year, from 0.25 per cent to 0.5 per cent in November, the UK’s rates have been at rock-bottom levels since the financial crisis of a decade ago. It’s been a long time since investors have had to cope with an environment of rising interest rates – some investors will never have been in this position.

How your investments could be affected

In which case, what impact on your investments should you expect? Well, generally speaking, an increase in interest rates is likely to have a depressive effect on the price of both shares and bonds.

In the case of shares, two factors come into play when interest rates rise. First, consumers’ mortgage repayments increase (as well as the cost of other debt), limiting their ability to spend money with businesses, which earn less as a result.

Second, businesses themselves have borrowings, so when it costs more to service this debt, their profitability suffers, as does their ability to invest for future growth and profitability. This hits their share price.

In the bond market, meanwhile, higher interest rates on offer from risk-free investments such as bank deposits make bonds look less attractive; demand for them therefore decreases and their price falls.

It should be said that these are general rules with plenty of exceptions. One big caveat is that an interest rate increase is a signal from policymakers that they believe the economy is strong enough to cope with the shock of higher borrowing costs; that can actually boost confidence and support investments.

Also, some types of business make money from interest rate rises. The financial services sector, in particular, tends to get a benefit from higher profit margins when interest rates are higher. Share prices here could therefore rise.

How to plan for higher interest rates?

Against this backdrop, how do investors position their portfolios for the possibility of higher rates? Well, the first point to make is that you shouldn’t be invested in assets where there is a risk of financial loss – and particularly not shares – unless you are able to take a long-term perspective. In that context, short-term market movements should be less concerning.

It’s also the case that regular savings can help smooth out the ups and downs of the investment cycle. Many investment companies offer plans that allow you to invest as little as £30 a month. In periods when share prices are falling, your fixed monthly investment will buy more shares, giving you a bounce when the market recovers.

Still, investors will want to be in funds where managers have the flexibility and discretion to fine-tune their investment portfolios for the changing market environment. Passive funds that simply track the market up and down are less attractive in these circumstances. Actively-managed funds, by contrast, have an opportunity to prove their value.

Investment companies, where the manager’s mandate is laid down by a board of directors with a legal responsibility to protect shareholders’ interests, are certainly worth considering in this regard. Over the long term, across a range of different types of market environment, the investment company sector has consistently outperformed other types of fund.