How to invest when interest rates rise

JThe Federal Reserve is finally acknowledging how entrenched inflation has become and looks set to take some serious action to at least begin to address it. One of the main measures is to raise interest rates.

Interest rates have been on a downward trend for about 40 years – since the last time inflation soared this high — making the rate hike something many investors haven’t experienced. The investment roadmap is a little different when interest rates rise, so knowing how to invest when interest rates rise is a skill that makes sense to learn. These five strategies can help you navigate what might otherwise be a difficult area in the market.

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No. 1: Keep your own balance sheet under control

Rising interest rates mean that the cost of debt will increase. If you have variable rate debt or debt that you will need to borrow more to pay off when it comes due, now is a great time to figure out how to pay it off or lock in fixed rates for it. The higher rates rise, the more expensive variable rate debt will become and the more expensive it will also be to take out new fixed rate debt.

By paying down or refinancing your debt while rates are still low enough, you can keep more of your income and cash flow under control. This is an important element to be able to ensure that you have money available to invest in the first place.

No. 2: Keep the duration of your bond fairly short

If your financial allocation plan requires you to hold bonds, then in a rising rate environment you will want to ensure that the bonds you hold are sufficient. those of short duration. Indeed, the longer the duration of a bond, the more the more it will fall when interest rates rise.

If your intention is to hold your bonds to maturity, your bond cash flows won’t change just because interest rates rise. If you’re using your bonds as ballast in your portfolio or plan to sell them before maturity, be aware, however, that low-coupon, long-to-maturity bonds can drop quite far as rates rise. These are the types of bonds that generally have longer durations and are therefore more affected by rising interest rates.

No. 3: Monitor the balance sheets of your actions

The same risks that affect your ability to repay your debts when interest rates rise also affect the companies in which you invest. As rates rise, their variable rate debt immediately becomes more expensive and their fixed rate debt becomes more expensive if they have to refinance it. as it matures.

It’s important to recognize this because a lot of corporate debt is structured as bonds where the company only pays interest until it is required to pay the full principal when the debt matures. Therefore, you’ll want to pay attention to both their debt level and their debt schedules – which are often noted in a company’s annual reports.

You’ll want to make sure the business still appears to be able to service its debt from its cash flow, even if those debts roll over at higher rates, requiring higher interest payments. If the debt market fears that a company can’t make these higher payments, he could put a business out of business by preventing it from borrowing new money. This kind of action could cause his stock to drop to $0.

#4: Look for companies with pricing power

As rates rise, leveraged businesses will typically see their margins squeezed by these higher debt service charges. Those who have the ability to pass these higher costs on to their customers via higher prices are more likely to survive than those who do not.

Given the recent inflation, you may be able to get an idea of ​​the strength of a company’s pricing power by listening to its earnings conference calls. If you hear comments such as “volumes have remained high even though we have priced to recover from commodity pressures”, that’s a pretty good sign that the company has at least some pricing power. .

#5: Focus on the value of the businesses you own

Investors generally want to get the best possible risk-adjusted returns for the money they are putting at risk in the market. As interest rates rise, the potential future returns they can earn on lower-risk investments like bonds improve, making higher-risk investments like stocks much less attractive. This is one of the main reasons the market has fallen recently as the Federal Reserve talks about the likelihood of a more aggressive interest rate hike.

In this framework, companies that already seem quite cheaply valued relative to their legitimate cash-generating potential could have far fewer drops as rates rise. After all, the lower the value of a company, the more its market price depends on its already proven results rather than his potential for rapid future growth. This makes it easier for investors to see a fast track to operations-driven returns, which can help support the stock prices of these companies.

Start now

With the Federal Reserve expected to raise interest rates by 50 basis points later this month to help fight inflation, the era of higher interest rates is very likely. This may well be your last and best opportunity right now to put in place your personal financial and investment plan to manage a higher rate environment. So start now and give yourself a decent chance of successfully crossing those rising rates.

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Chuck Saletta has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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