Why Rates Matter To Your Portfolio
If you hold mutual funds that are allowed to invest in all kinds of stocks, what Alan Greenspan and the Federal Reserve decide to do this year and beyond should make little difference to your investment decisions. As a holder of a broad-based fund, you are doing more than just buying a bunch of companies: You also are investing in the brains of your fund manager. Part of the service you should expect is that your manager is able to anticipate changes in interest rates, or else to react to changes very quickly.</br></br>But if you invest in individual stocks or sector-based mutual funds, interest rates matter greatly, the same way they do to the manager of a growth or general-performance fund. A good manager would dump certain stocks and embrace others if assumptions about future inflation changed. All stocks do not react the same way to higher interest rates, and no major market features more differentiated behavior among stocks than the United States. If interest rates are set to keep rising, it pays to have a plan of action.</br></br>To see why rates matter so much to certain kinds of companies, imagine your household has little or no debt at all. You pay rent on an apartment every month, pay off your credit card in full regularly and take the bus to work. You are saving for some day in the future when you will buy a car or a house, maybe five or eight years down the road. How do interest rates affect you? Probably only inasmuch as higher rates get you a higher return on your savings account.</br></br>But if you had a mortgage and car payments tied to movable interest rates, then a major increase in rates would actually hurt you, maybe quite badly, as your mortgage payments increased.</br></br>The same goes for companies. Higher interest rates can kill businesses that are heavily leveraged (have a lot of debt), or those that invest heavily in bonds. Insurance companies hold piles of bonds, for instance, because they have so much premium money to invest. Because bond prices move in the opposite direction to rates, higher rates make the insurance company's bonds worth less.