When interest rates change because of the monetary policy set by a central bank (in the Philippines, it’s the Bangko Sentral ng Pilipinas or BSP), you’ll often see some changes in the value of your investments.
Why does this happen? And what effects can you expect in your portfolio when interest rates change? Read on to find out more.
Tight vs. loose policy
First, let’s talk about interest rates. When an increase is mentioned in the news, it refers to the key interest rate, which is used by banks as the basis for determining how much they will lend money for.
When the key rate goes up, loan rates also rise. That makes it more expensive to borrow money, and so less people and institutions do so.
This is the BSP’s way of slowing down the economic growth, economic activity and economic transactions because when borrowing decreases, spending does as well. That limits the amount of money circulating throughout the economy, and can slow increases in the price of goods and services.
When the BSP or any other central bank increases the key interest rate, this is called a tight monetary policy. It’s used to manage inflation and to slow down an economy that is seen as overheated (when output can’t match demand).
When the key rate is decreased, on the other hand, this is called a loose monetary policy. That happens when a central bank wants to encourage economic growth by making it cheaper to borrow money.
What happens to your investments?
When the key rate goes up, there are several things that are likely to happen. One of these is a dip in bond prices in the secondary market. That’s because new bonds will have a higher coupon rate, so demand for older issuances that have a lower rate will drop.
In fact, there is an inverse relationship between interest rates and bond prices. As one rises, the other falls.
Another thing that may happen is that stock prices will dip. This also involves the attractiveness of new bond issuances with higher coupon rates. Many investors may choose to put their money in bonds instead of stocks, causing demand to fall, and prices too.
Also, higher interest rates may keep companies from borrowing money in order to expand. This is likely to have an effect on their performance, which is another factor that investors consider.
There’s also a psychological aspect to the effect on both bonds and stocks. When rates go up, people and businesses will cut back on spending, and so investors may not put more money in. This causes demand to fall, and could also affect prices.
When the key rate is lowered, on the other hand, the opposite is likely to happen. Bond and stock prices will rise, spending increases, and the economy could grow rapidly.
You’ll probably see the effect of a change in interest rates if you invest in bonds or stocks directly, or indirectly through a pooled fund like a Unit Investment Trust Fund (UITF).
Should you worry about a change in interest rates?
If higher interest rates cause your investment’s value to drop, remember that this may not be permanent and that they’ll recover over time, especially if the organization’s fundamentals are sound and it continues performing well.
Remember though that this isn’t guaranteed, and so there’s also a chance that the value will not go back up to its previous level.
In the case of lower interest rates helping your investment grow, feel free to enjoy the benefits. Keep in mind that while the situation may change in the future, you shouldn’t pull your money out early because that would get in the way of successfully reaching your goal.
