Economical and financial landscapes experience continual fluctuation, with certain groups and entities able to either gain or lose from a given change. When the Federal Reserve institutes a rate hike, the effects can be far-reaching and varied, with some entities like savers and equity REITs benefitting and others not.
Short-term bond investors
Short-term bond investors are well-positioned to benefit from a Federal Reserve rate hike, as newly issued bonds experience higher yields. But investors should always keep in mind the inverse relationship between bond yields and prices. Short-term bonds are less sensitive to rate changes and can be reinvested into higher-yielding bonds when they mature, making them a smart investment choice when interest rates rise. This means, for example, if the Fed increases interest rates from 2% to 2.25%, a short-term bond with a maturity of two years may see an increase in yield from 2.1% to 2.35%.
On the other hand, long-term bonds may experience a decline in prices due to their sensitivity to rate changes.
From a Fed rate hike, government bondholders may also benefit as newly issued bonds have higher yields, providing potential for greater income and total return. This happens due to the inverse relationship between bond yields and prices, where rising yields cause prices of current bond issues to fall. Short-term bonds are less sensitive to climbing rates, making them attractive to investors looking to maximize cash and debt returns.
Here’s is an example: if an investor purchases a $1000 bond with a 2% interest rate and the Fed raises the rate to 3%, they can earn a $30 interest payment, which is 1% more than before. However, increase in interest rates will cause bond prices to fall in value.
Money market funds
A rate hike by the Fed can benefit money market funds, as higher interest rates lead to increased returns on the securities held by these funds. A 1% increase in interest rates can result in an additional 1% return for money market funds, for example. Financial experts predict that top-yielding savings and money market rates could reach up to 5.5% APY by mid-2023 and settle at 5.25% APY by the end of the year.
On the contrary, a rate hike may also increase borrowing costs for banks and other financial institutions, which could potentially slow down economic growth and negatively impact the stock market.
Interest rates on savings accounts and certificates of deposit usually rise in response to the hike. This means that savers will receive higher yields, which can potentially result in an extra $200 of interest payments for a $10,000 savings account. This calculation is based on a 1% rate hike. Financial institutions may offer higher interest rates on high-yield savings accounts to remain competitive and attract deposits. But, if the saver also has some form of debt, such as a loan, credit card, or mortgage, they may not be better off due to higher interest payments.
Meaning, while the saver may benefit from the rate hike, they may also be paying more on their debt.
Retirement funds can benefit from a Federal Reserve rate hike, but the impact depends on the type of investment. Bondholders may earn more, but existing bondholders should be cautious as bond values decrease when rates rise.
Mutual funds in 401(k) plans may experience a decrease in share price, but income may rise as new holdings pay higher rates. Annuity providers may see increased returns. Retirees must be aware that their pension needs to grow more than inflation to keep up with living costs. For instance, if inflation hits 12%, the pension must grow by more than this amount.
Here’s how it happens: a retiree invested $10,000 in a bond paying 2% interest, expecting to earn $200 annually. If the Federal Reserve hikes rates by 1%, the bond’s value drops, and the retiree may have to sell it for less than $10,000. But if they invest in a bond paying 3%, they will earn $300 annually, a $100 increase.
Federal Reserve’s any rate hike leads to an increase in returns on insurance companies’ fixed-income investments. It means when Fed increases 1% interest rate, it raises the rate on bonds by nearly the same amount, thereby increasing profitability for insurers who invest in a mix of stocks and bonds.
Rising interest rates, however, may decrease the value of existing, lower-earning bonds in life insurers’ portfolios, leading to increased insurance shopping among policyholders and higher claims costs due to inflationary pressures. The impact of a rate hike on insurance companies is, therefore, slightly complex, with both potential benefits and drawbacks.
Life insurance companies
The higher interest rates can translate to higher returns on the investment portfolios of life insurance companies, so they typically benefit from a fed rate hike. This is due to the fact that life insurers typically tend to invest in long-term bonds, which are more sensitive to interest rate changes. Likewise, higher rates can improve their spreads over liabilities.
Despite the decrease in the value of existing bonds, life insurers can protect themselves from inflation by locking in premiums on term life insurance policies and using strategies with permanent life insurance policies.
Let’s assume that a life insurance company has a portfolio of $10 billion invested in long-term bonds, and the average yield on these bonds is 3%. If the Fed were to raise the interest rate by 0.25%, then the yield on the bonds in the portfolio would increase to 3.25%. This would finally result in an additional $25 million in annual income for the insurance company.
For-profit companies like REITs, or Real Estate that own and operate income-producing properties, can benefit from a Fed rate hike by increasing their rental income. An example of this is when the rate hike reflects improvement in the underlying fundamentals, which increases the demand for rental properties. Later, when interest rates rise, REITs will incur higher interest expense, but the rental income will offset this. Or, if the rate hike affects future earnings growth, investors can still benefit from the expectation that REITs dividends will keep up with inflation.
In 2023, REITs are expected to deploy capital, increase debt and equity issuance, and possibly partake in M&A activity.
Large-cap technology stocks
Large-cap technology stocks are known to be more stable than small-cap stocks, making them a likely beneficiary of a Fed rate hike.
As rates increase, trading activity often rises and investors receive higher interest income. However, these stocks are also vulnerable to higher interest rates, as the present value of future profits is reduced, leading to slower economic growth.
What’s more, when the Federal Reserve raises interest rates, it tends to cause the stock market to drop, making large-cap technology stocks particularly susceptible to fears of rising interest rates. For an instance, GDP growth slowed considerably in 2022 when the Federal Reserve tightened interest rates. This was likely due to the reduction of the present value of future profits.
As the Federal Reserve’s rate hikes can have varying effects on different entities, only fewer ones can easily benefit from this. Government bondholders, life insurance companies, and equity REITs may also benefit, but their investments could be more sensitive to rate changes. Whoever the beneficiaries are, it’s noteworthy that large-cap technology stocks are particularly vulnerable to rising interest rates and may experience a slowdown in economic growth. Thus, taking a holistic approach when considering the impact of a Fed rate hike on different sectors has obviously a true significance.