Low Interest Rates and Their Effect on the Stock Market - January 2nd 2013
Written by guest contributor Eve Sharpe
Interest rates affect all kinds of investments and lending. Low interest rates are good for people borrowing money and for those looking toward taking out a mortgage. They are poor for those investing in bonds, savings accounts and pensions. They also affect stock markets and the types of investments people and companies make. Interest rates determine the cost of borrowing and the potential yield for certain investments, though any change to them tends to take 12 months to take full effect.
Interest rates can be defined as the cost of using another person or organization’s money. It is the amount of profit they make from allowing you to do what you like with a chunk of cash. These are paid either on loans lent to someone or on savings invested with a bank. Interest rates help to govern one of the two means companies have of raising fresh capital for investment. These are through selling stock or assets, and through borrowing money. For the latter, there are three main types of borrowing, which are bonds, equipment financing and bank loans.
In times of economic hardship, governments and central banks such as the Federal Reserve, seek to improve inter-company lending and financing in order to kick start the economy. They do this through the use of low interest rates. In America, this rate is known as the federal funds rate and is the rate of interest commercial banks pay to loan money from the Federal Reserve. In theory, lower interest rates are attractive to companies and encourage the downward flow of money. When this fails, central banks turn to quantitative easing. As interest rates, high or low, affect liquidity in banks and therefore investment companies, rates have a huge impact on the stock market as a whole.
Stock and Bond Markets
Naturally, investors wish to balance the rate of return of an investment with the likelihood of a return. Unsafe bonds have the highest interest rates, but are the most likely to fail and not be repaid. For safe bonds, the opposite is true. In the bond market, the yield or return, is based on the quality of the bond. Rating agencies determine the interest rates paid on such corporate and government bonds. That said, the relationship between bond prices and interest rates is that the value of the bond increases when interest rates lower. The reason is simple; the interest rate of the bonds is above that of lending, making a better return on investment.
The general interest rate is separate to those of individual bonds. A low interest rate will cause an increase investment, as it is easier to raise capital. This tends to lead to an increase in stock values. The opposite is true if there are high interest rates, which dampen investment in stocks. With rising stocks in a low interest rate environment, this is good for dividends on held stock, but dampens trading as investors will look to sell at peak value, while investing in stock at a low ebb, hoping for a return.
An alternative to ordinary stocks and bonds, are dividend stocks. These are bond like stocks that offer a higher yield than normal stocks. History suggests that in low interest rate environments, dividend stocks outperform normal stocks. One reason for this is safety. Another is that these stocks proliferate during times of economic struggle, thus they are designed for these exact circumstances.
Criteria for choosing dividend stocks include the beta coefficients, which measure stock volatility compared to the S&P 500, the performance of blue chip stocks, which are seen as the top stocks around, free cash flow of the stocks offered, which is used to determine the likelihood of dividend payouts and finally, the history of payment, which shows how often and at what level such dividends have been paid out in the past. When looking at dividend stocks, consider the dividend tax rate, future changes and how it affects your finances before investing.
For individual savers and retirees, knowing what to do with investment money can be difficult during a low interest rate era. The Federal Reserve believes that low rates could continue until at least 2014. For some, this means keeping savings under the floorboards, while others look for higher yield investments. As with any era or economic situation, investments need to be smart and to cover the balance of probabilities.