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Interest rate matters for investments

After 30 years of falling, interest rates are expected to rise again from next to nothing. Brian Kilb explains what interest is and how it matters to investors.

Joel Dresang: Brian, we talk all the time about interest rates and how interest rates and corporate earnings are the chief concerns for long-term investors. Let’s focus on interest rates, though. How do you describe what interest rates are?

Brian Kilb: Well, Finance 101 Joel: Interest rates are the cost of using money. I think those costs relate primarily to two basics.

One is the time value of money. If I have $1 today, that $1 is worth something different down the road. Interest rates allow us to compensate somebody for that deteriorating time value of money.

The second component is, if I’m going to give you some money, I’ve got to get paid something for the risk that I take that you may not pay me back. So there’s an element of risk involved, buried in the cost of interest rates as well.

Joel: Explain why interest rates matter to investors.

Brian: So on one side there’s a cost of the money. The other side is the investing side, the saving side. If I’m going to lend you my money, I’m going to get paid something back for that. So there’s a return on my capital. There’s a return for the risk that I’m taking. That interest or return on capital should be part of any portfolio.

Joel: What about for stock investors? How do interest rates figure into that?

Brian: Well, I think there are different ways to get paid for an investment. The difference between stocks and bonds primarily is the difference between risk and return.

On the stock side, you own a company, if the company does well you do well, if the company doesn’t you don’t. On the bond side, you’re mostly working toward a fixed payment of interest.

Now, on the stock side you may even get a little bit of a cash dividend. That may be a little bit of income or a little bit of interest, as it were, for your stock, but you still have the upside potential and downside potential of stocks in the success or failure of that company.

Joel: So we’re ending nearly three decades of declining interest rates. Interest rates are expected to start going back up again. What does that mean to investors?

Brian: Well, a reminder that the price of bonds works inversely to the direction of interest rates, so presuming that interest rates will be on the rise, albeit very slowly, it’s possible that bond prices will go down at some point in time. So you want to build your bond portfolio, with that in mind.

Make sure you have high-quality, short-duration bonds that will move very little in relationship to interest rates to protect your bond portfolio and minimize the risk in the bond side, as we go through this rising-rate interest rate environment.

Joel: What about on the stock side?

Brian: Well, I think on the stock side, what it does is low rates make the appeal of dividends in your stock portfolio more attractive. So if I can get 2% on a fairly safe corporate bond, well doesn’t that make my 2% dividend on my stock more attractive? Not only do I get the surety of the dividend, but I have the upside potential of growth as my company performs well and earnings grow down the road.

So I think the low interest rate environment on bonds does push you, if you will, or provide an incentive for you to rely more heavily on stocks because of the attractive nature of the dividend and growth potential.

Joel: Overall, do you see most balanced investors doing much of a change because of what’s going on in the interest rate environment?

Brian: No. I think over the last few years we’ve been heading this direction.

Everybody has a certain tolerance for risk. To the degree that you might favor stocks and growth for your portfolio, you never want to go past the point where you’re putting inappropriate amounts of risk in your portfolio, irrespective of the nature of interest rates or attractiveness of stocks in your portfolio.

Brian Kilb is executive vice president and chief operating officer of Landaas & Company.

Joel Dresang is vice president-communications at Landaas & Company.

Money Talk Video by Peter May and Jason Scuglik

(initially posted June 3, 2016)

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