Understanding interest rates

If you're wondering what interest rates are and how they can affect your investments, this article covers all the basics to help you understand how they work.

Understanding interest rates and how they affect investors

There’s a lot of interest in interest rates these days, and understandably so. In 2023, most Canadians became aware of how rising rates impact borrowing costs — many are now paying higher monthly mortgage payments after rates climbed in 2022 — but did you know interest rates can impact investors, too? Just as it’s important to know how rates impact your finances, it’s also important to know how rates can affect your portfolio.

Interest rates represent the amount borrowers pay lenders to borrow money, usually expressed as a percentage of the loan’s principal per year. For instance, if you borrow $100 and get charged a 10% annual interest rate, you’ll owe the lender $10 when the year is up. Rates vary depending on who’s borrowing, who’s lending and for how long. They are also affected by external factors, such as inflation, economic cycles and central bank policy.

While you may encounter interest rates in a variety of places — from credit card agreements to mortgage and student loans — these are the rates that investors pay particularly close attention to:

• Policy rate

When you hear rates have climbed by 0.25% in the news or around the water cooler, the speaker is usually referring to the policy rate — also known as the overnight lending rate. The policy rate is set by the Bank of Canada and its respective counterparts in other countries.

• Prime rate

Another term you’ll hear people talk about is the prime rate, which is the rate that banks charge their most credit-worthy customers for borrowing funds on, say, a line of credit.

With income investments, an investor becomes a lender: When you buy a debt instrument like a bond or a Guaranteed Investment Certificate (GIC), for example, or put money into a high-interest savings account (HISA), you’re in effect lending money to that financial institution, which then pays you interest for the use of those funds

There are many different types of interest rates, and each loan comes with its own set of terms specifying how the interest will accumulate and how the loan will be repaid. Here are some examples:

• Simple vs. compound

Under simple loan terms, the borrower pays the lender the interest owing on the initial principal at scheduled intervals. Bonds and short-term GICs usually work this way. Other debt arrangements, such as multi-year GICs and HISAs, typically feature compound interest, which means the issuer pays interest on previous years’ interest as well as the principal.

• Fixed vs. variable

With a fixed interest rate, the rate stays the same over the term of the loan. With variable interest rates, the interest paid may be adjusted upward or downward by the lender, usually depending on how high or low the overnight lending rate goes.

Interest rates are not pulled out of thin air. Central banks set the policy rate — the rate at which they lend to commercial banks — based on their understanding of the economy’s health and inflation. If a central bank wants to stimulate the economy, it might lower rates to make it cheaper for businesses and consumers to borrow. Lenders will then take their cue from the central bank when setting their own consumer-facing interest rates.

There are many factors that can affect interest rates, but inflation — the rate at which prices for goods and services rise over time — is one of the most influential. Central banks use interest rates to help control inflation. By adjusting interest rates, a central bank — like the Bank of Canada — can influence how people spend money. Higher interest rates for example may discourage people from borrowing and spending. As demand falls, prices typically stop rising, and that contributes to slowing inflation. Lower rates, on the other hand, can encourage borrowing and increased spending.

While higher rates may not be ideal if you have a variable rate mortgage or are looking to borrow money, they may help your investments in certain circumstances. Here’s how different investments fare when rates go up:

• Savings accounts

The interest paid on high-interest savings accounts is usually set to a variable rate — so when interest rates rise, account holders earn a higher return. Keep in mind, the interest rates offered on these accounts may be below the current rate of inflation, meaning your real return could be negative.

• GICs

Rising interest rates make the yield on risk-free GICs more attractive. After languishing for years, newly issued GICs became competitive again in 2023, with rates climbing above 3%. If you’re holding on to an older GIC, however, you may not benefit because many GICs are not redeemable. If you locked into a five-year GIC when interest rates were much lower, then your investment will underperform when compared to newly-issued GICs.

• Bonds and bond funds

Higher rates mean the bonds you buy today pay higher interest (known as the “coupon rate”) than a year ago. Many Canadians invest in bonds through mutual funds or Exchange-Traded Funds (ETFs). When rates rise, the price of the lower-yielding bonds these funds already own go down, resulting in a capital loss for the funds’ unitholders. It’s also possible to buy so-called real-return bonds which boast more stable prices and coupon rates that go up or down with the market.

• Stocks and equity funds

While rising rates can help your fixed-income investments, they may hurt the equity portion of your portfolio in a couple of ways — at least in the short term. First, they can make it more expensive for companies to borrow money to expand. The more they must pay lenders, the smaller their earnings may be and the less they will have to return to shareholders. Second, as fixed-income investments become more attractive, money gets reallocated to them from equities, meaning there are fewer investors competing to buy shares. Of course, interest rates affect every sector differently. Before investing, it can help to research how the sector has historically performed during periods of rising or falling interest rates.

While it’s always a good idea to keep an eye on your investments, you may want to pay closer attention to your portfolio when central banks start to adjust interest rates. Rising and falling rates can affect the overall performance of your portfolio in various ways. Here are some things to remember in a rising interest rate environment:

• Impact on fixed income
  When interest rates rise, bond prices fall. That’s because newly issued bonds charge a higher interest rate — known as a coupon — which makes previously issued bonds that offer a lower interest rate less attractive. Generally, interest-bearing investments such as bonds and GICs offer an improved risk-adjusted return when interest rates rise.
• Impact on stocks
  Changes to interest rates don’t impact equities in the same way they affect bonds, but that doesn’t mean stocks are immune. Because fixed-income investments offer a higher risk-adjusted return when rates rise, stocks may become less attractive as investors reallocate money from the equity side of their portfolios to fixed-income investments.