When interest rates are low or high, investors must consider what a reversal will do to their returns. At both ends of the scale (high and low), investors often assume a reversal will come.
The question is when will interest rates change direction, by how much and what does a reversal mean to my investments.
A couple of general guidelines:
- When interest rates are low, you want to lock in debt (mortgages, auto loans, and so on) for as long as practical and keep savings in short-term instruments (money market funds, for example). Consider investments in assets that will appreciate with rising interest rates (financial stocks, for example).
- When interest rates are high, you want to lock in savings (bank CDs, bonds and so on) for as long as practical and limit asset purchases that are inflated by high interest rates and may suffer when rates fall. Industries such as construction often benefit with falling interest rates.
Fixed income investors (CDs, bonds) should evaluate their motives for these instruments when considering a strategy.
For example, if you are chasing current income, rising interest rates can hurt your plans because your bond will not be worth as much (newer bonds paying higher interest rates will be valued higher).
However, if you are interested in preserving your capital and plan on holding the bond to maturity, rising interest rates are not as large of a concern. There are strategies such as bond ladders to help you accommodate rising interest rates.
On the other hand, falling interest rates will make your higher-interest bond more valuable if you want to sell it before maturity.
Picking when interest rates will reverse is challenging at best. A prudent course of action is to take advantage of those investments that will not be significantly hurt by a change in direction. You may not hit all the potential gains, but you will be better protected when interest rate change comes.
