Financial markets have been quickly trying to re-price expectations of a looming interest rate hike from the Bank of England. For example, the two-year UK Government bond yield spiked to 0.75% yesterday. This is seen as the likely position interest rates will be at in two years’ time. With economists at some large banks expecting a November hike, I need to invest smartly around such an event. Here’s what I’d do.
The deal with interest rate hikes
Typically, interest rate hikes are bad for the stock market. This is because it makes it more expensive for companies to raise money from the debt market. Corporate bond yields typically track the Government bond yield, plus a premium to reflect the added credit risk. So if interest rates pop 0.5% higher, this likely moves the corporate yield for a company higher by 0.5%. If the business wants to issue new debt, it’s suddenly become 0.5% more expensive.
This might not sound like a lot, but we’re talking about 0.5% on hundreds of millions of pounds potentially. It really does add up! Higher interest costs ultimately could lower profit.
Allocating towards certain sectors
Now we’ve established why interest rate hikes are negative for the market generally, how should I invest my £1,000? Firstly I’d ensure that I split the amount into half a dozen or so companies. This way, I reduce my risk of one weak investment wiping out my whole £1,000.
Second, I’d look at companies that will be least impacted by higher interest rates. For example, banks. They’re providers of loans, mortgages and other liability-driven products. At the same time, banks pay out interest on cash balances. The key way revenue is made is in the difference between the interest paid out and the interest charged.
With higher base rates from the Bank of England, this margin can increase. For example, with rates at 0.1%, high street banks can’t go lower than paying 0% on my cash account. But at 0.5%, I’m still unlikely to get paid anything on my account. Yet even if I get paid 0.1%, the margin the bank makes has jumped from 0.1% previously to 0.4% now.
Therefore, I’d look to buy shares in major retail banks here in the UK. Two examples include NatWest and Lloyds Banking Group.
One risk here is that banks still have to borrow money by issuing bonds, so the rate hikes would still hurt them to some extent.
Making use of dividend income
Another way I’d look to invest my £1,000 despite interest rate hikes is via dividend stocks. These pay out income once or twice a year. The yield offered by some stocks is considerably higher than the base rate, even after a potential hike next month!
For example, I wrote yesterday about two FTSE 250 stocks that have dividend yields above 10%. So if I invest in these stocks with a long-term time horizon, I have a buffer. If the share price falls lower when rates are hiked, I can hold the stock and enjoy the generous dividend yield. In years to come when the market is used to higher rates, I’d hope the share price would also recover.
So even with uncertainty surrounding interest rate hikes in the UK, I can still look to allocate £1,000 now to maximise my returns.