How do interest rates affect the market?

Hey there, time traveller!
This article was published 06/12/2023 (709 days ago), so information in it may no longer be current.

Dear Money Lady,

I am stumped on the stock and bond movements when interest rates move up or down. I always thought, when interest rates increased, bonds would also increase, and stock values would decrease, and the reverse would be true when interest rates decreased. However, when I look at the current situation, I do not see this, so I am confused, or have I been mistaken all along? Could you please clarify how this is working in the current environment or how it really works? And would it be a good idea to buy bonds or mutual funds in my TFSA next year?

Thanks,

Ron

That is a great question, Ron – one a lot of people would like clarification on, so thank you for asking.

The stock market is progressive and regressive at times, and the reaction to interest rates here at home – as well as the reaction to worldwide instabilities — has a lot to do with how it moves.

Stock prices react to good or bad world events very quickly, owing to the speed with which news is spread. Global events, and especially events in the United States, have a lot to do with market swings. Interest rate increases from central banks do cause stock prices to decline. This is because the higher interest rates translate into higher borrowing costs for businesses, and when this happens companies must spend more on their loans and therefore reduce production or halt expansions. This slowdown in growth causes share prices to fall. If enough companies have the same problem, they could drag down entire market indices and affect the S&P or the TSX Composite Index.

If we turn the bond market and interest rates, you will see that they have an inverse relationship. When interest rates go up, bond values go down. But I don’t believe you should be that concerned with this phenomenon if you plan to purchase institutional bonds in a laddered portfolio. If you intend to hold the bonds to maturity, the interest rate risk is of no concern since it only applies if you need to sell the bonds before they reach maturity (selling at a discount to par value – or below the bonds’ guaranteed sale price at maturity). Bonds that are traded in the secondary market are completely vulnerable to fluctuating supply and demand and, of course, any minor changes in interest rates.

Let me give you an example, so you can see how it works.

Let’s say that Ron buys a $1,000, 10-year bond with a coupon rate of two per cent, sold at a discount to mature at par. That means he paid $800 for the bond and if he holds it to maturity, it will earn $200 in interest and mature at $1,000.

Now then, interest rates have risen, and another investor can buy the same 10-year bond with a coupon rate of three per cent. This investor can purchase at a discount, too, for $700 and if they also hold the bond to maturity, it will earn $300 in interest when it matures in 10 years. Here’s where most people get confused. The first bond now becomes less valuable because it technically is producing less income and therefore its market value has declined. If Ron wanted to sell this first bond before the 10-year term ends, he would have to sell it in the secondary market for less than its $1,000 value. Economists thus conclude that a rise in interest rates pushes down the bond market value over time.

Unless you are buying and selling bonds daily, or you are buying bonds in mutual funds and exchange traded funds (MFs and ETFs), none of this really matters. When you buy bonds in a managed account, however, it matters if the interest rates rise, since your Bond-MF value will most likely decrease substantially. Bond MFs or ETFs usually buy and sell bonds continuously over time and before maturities, so any changes in interest rates will make a difference in your investment value.

The best way to get into the bond market, and something I used to do for my clients in the past, is to purchase institutional bonds directly, in a laddered fixed income portfolio, and hold them to maturity. You will therefore use the rising rates to buy more institutional Triple-A bonds, to hold more and make more in the future. I have seen a lot of investors do very well with this method, which I use myself. Canada held over $1.976 trillion dollars in fixed income investments as of spring 2023.

Here is a tip: BMO Nesbit Burns holds the largest bond desk in Canada with all other financial institutions using its platform. If you can, speak to a BMO NB investment adviser to create your own laddered investment portfolio and guarantee a secured future.