The U.S. Federal Reserve will hold a policy meeting Wednesday and Thursday this week. The meeting has incited a media frenzy as officials will discuss if now is the appropriate time to impose an interest rate hike.
All of the buzz has investors wondering: How do rising interest rates affect the stock market?
To be a prepared investor, it's important to understand how rising rates affect different assets. Here's how four popular asset classes perform when interest rates go up...
How Do Rising Interest Rates Affect the Stock Market? Investment No. 1: REITs
Real estate investment trusts (REITs) are companies that own or finance income-producing real estate properties. They're typically associated with shopping malls, offices, hotels, and apartment buildings. REITs are high-yield investments that pass 90% of their profits to shareholders.
According to Money Morning Chief Investment Strategist Keith Fitz-Gerald, a Fed interest rate hike will not kill all REIT returns.
"Contrary to what a lot of people believe, REITs have historically done well when the cost of money is increasing," said Fitz-Gerald earlier this year. "REITs are not the investing zombies many investors think when it comes to rising rates."
REITs usually perform well when the 10-year Treasury bond yield is high. The yield has hovered above 1.5% over the last year. The Dow Jones REIT Index is up 4.1% over the same period.
Between 1994 and 2013, there were nine separate periods when the U.S. Treasury yield was more than 1%. During one stretch in 2009, REITs saw their highest average return of 50.1%.
But you can't just bank on 10-year Treasury yields climbing because the Fed raised rates. You see, the 10-year bond is affected by more than just interest rates.
That brings us to the next investment...
How Do Rising Interest Rates Affect the Stock Market? Investment No. 2: Bonds
Treasury bonds are issued by the government to finance debt. When investors buy bonds, they're loaning money to the government, which promises to pay them back in full with regular interest payments. Bonds are typically safe investments because they offer steady income streams during times of volatility.
However, Treasury bond prices have an inverse relationship with interest rates. That means an interest rate hike this week would decrease bond prices.
[mmpazkzone name="in-story" network="9794" site="307044" id="137008" type="4"]
The reason for the inverse relationship has to do with newer bonds. When interest rates climb, the federal government issues new bonds at the higher rate. That makes existing bonds with lower rates much less valuable.
Bond prices also have an inverse relationship with bond yields. That relationship mostly depends on investor confidence.
When confidence is high, the Treasury bond's price falls and yield rises because investors think they can find more profitable investments and don't need to play it safe. When investor confidence is low, the bond price appreciates and yield falls because there's more demand for this safe investment.
How Do Rising Interest Rates Affect the Stock Market? Investment No. 3: MLPs
MLPs are unique because they distribute most of the cash earned from normal operations to investors. Because they're required to give this cash to shareholders, they're left with little cash to fund future projects and have to borrow money to fund them.
That means rising interest rates affect the cost of funding for MLPs.
For example, let's say a MLP starts a drilling project that costs $200 million and will generate $20 million in revenue each year. The company needs to borrow $200 million to fund the project. If it costs the MLP 5% a year to borrow the money in a low interest rate environment, its annual interest expense is $10 million. After paying the cost of funding, the company would earn only $10 million in revenue a year.
If interest rates rose from 5% to 8%, the interest expense would increase to $16 million. That would decrease annual revenue to $4 million. If rates rose past 10%, it wouldn't be smart for the company to pursue the project since it would be left with debt.
Ultimately, high interest rates can seriously eat into a MLP's revenue and profitability. That's because they rely on external financing rather than internal cash flow to fund projects.
Despite being strapped for cash, MLP stocks have historically outperformed the broader market during rate hikes.
From the June 29, 2006, rate hike to the same date in 2007, the Alerian MLP Index smashed the S&P 500 by 18.7%. The rate was increased by 25 basis points - the exact same amount the Fed would hike it by this week. That means MLPs could follow a similar pattern if the assembly implements a rate hike.
How Do Rising Interest Rates Affect the Stock Market? Investment No. 4: Common Stock
Rising interest rates don't have an immediate impact on the general stock market. The only thing rate hikes do is make it more expensive for banks to borrow money from the Federal Reserve.
Still, many investors worry that an interest rate hike will have a devastating effect on the market. They're afraid a massive sell-off will occur after the two-day assembly.
But according to Money Morning Capital Wave Strategist Shah Gilani, there's no reason to panic. The market has prepared for a small rate hike for months.
"As a market buster, a small rate hike shouldn't be a game changer," said Gilani. "A bump in rates 25 basis points has already been telegraphed for so long that it's mostly baked into stock prices now."
Alex McGuire is an associate editor for Money Morning. You can follow him on Twitter at @AlexMcGuire92.
More on Interest Rates: The FOMC meeting this week will be the sixth scheduled meeting of 2015. Fed Chairwoman Janet Yellen will follow with a press conference. Here's what investors are watching during the two-day assembly...
- The Wall Street Journal: How Your Rates Will Move When the Fed Does