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Interest rates in the developed world are at an historic low. In the UK, the Bank of England’s (BoE) base rate now sits at 0.10%, driving down the prices of many fixed-term mortgage deals from lenders across the country. Yet, given how low interest rates currently are, many investors are concerned about what will happen to their portfolios when they inevitably rise. After all, unless the base rate enters negative territory (a distant possibility), it cannot go much lower than 0.10%! In this article, our financial planning team at Hanson Financial Services addresses the question of how changing interest rates affect investment strategy and decisions. We hope you find this content useful. Please contact us if you’d like to discuss your own investment strategy with us via a free, no-commitment consultation.
The impact of interest rates
The BoE base rate, in very simple terms, sets the interest rate for the UK Government when it wants to borrow money. The lower the base rate is, therefore, the cheaper it is for the country to borrow money. This is one reason why, in 2020 and 2021, the UK has been able to borrow and spend so much on fighting COVID-19 (e.g. vaccine development and roll-out) and providing costly financial support measures to the population, such as the Job Retention Scheme. This is, arguably, one positive aspect of low interest rates. Another effect of a low base rate is that UK lenders – i.e. banks and building societies – tend to follow its movements. As such, this makes it easier for consumers to borrow money, say, to buy a house.
However, low interest rates do have their downsides. For investors looking to lend money to the UK government to get a return (i.e. by buying gilts), lower interest rates lead to lower returns – perhaps which struggle even to beat the rate of inflation. For savers, moreover, it means lower interest on the money stored up in their bank accounts. This dynamic can lead many investors to move more of the capital in their portfolios into other assets, such as equities, where they hope to generate a better return at the cost of higher investment risk. This is sometimes a wise decision to take under professional financial advice, but not always.
Yet, what if interest rates were to rise in 2021, 2022 or beyond? Does that mean a change of investment strategy is required?
Rising interest rates
Firstly, it is not predetermined that interest rates will rise in the near future. They may, indeed, remain steady for some time. In the UK, it may even transpire that the BoE chooses a “negative” base rate – an experiment tried in Japan, for instance. As such, investors should be careful not to plan their portfolios as if a rise in interest rates is imminent. Secondly, the whole point of an investment strategy is that it should be long-term; prepared for many different scenarios in the wider market and economy. It will also benefit from being flexible, allowing you to pivot quickly if absolutely necessary. Tying up your portfolio in lots of “illiquid assets”, therefore, is often a risky idea – since you cannot sell them easily if you need to.
With all of this said, there are some principles to consider when imagining how a rise in interest rates may affect your portfolio (discussed with your financial adviser):
- Mortgages. If you are a homeowner – or hope to be soon – then you may wish to take full advantage of a low interest rate environment, while it lasts. Imagine you are living in your “forever home”, and you are paying a mortgage on a (more expensive) standard variable rate. Here, you could save money by taking out a long-term, fixed-term mortgage (e.g. 5 years). If interest rates later rise, then your monthly mortgage payments will not rise too.
- Take care with cash. Many people are frightened of investing their money and prefer to keep long-term savings in a regular savings account, or Cash ISA. Here, the problem is that interest rates have been low for a long time in the UK. Most struggle to beat inflation which means, in real terms, you often lose money by saving in cash. As such, it may be better to put long-term savings into assets which generate a better return, spreading risk out by investing across multiple companies, sectors and countries. If interest rates later rise, however, it may be more worthwhile to start moving more of your capital into cash savings, since the interest rates in the marketplace will likely also improve.
- Use prudence with bonds. When you buy a bond, you lend money to a company/state in exchange for eventual repayment – with interest. If you buy one when interest rates are low, bear in mind that its market value will decrease if you later wish to sell it and interest rates have risen (since buyers can get better rates elsewhere). Be careful, therefore, to speak with your financial adviser about how to wisely include fixed-rate assets in your portfolio before rushing to buy lots of them.
Are you interested in talking to a financial adviser about your pension and investment planning needs? We’d love to assist you here at Hanson Financial Services.
Please contact us to arrange a consultation with our team – free and without obligation – to gain more clarity and peace of mind over your financial plan.
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