What interest rate changes can mean for investors

There’s always lots of attention in the news about changes in interest rates and how they affect savers and borrowers, but less on what it means for investors and pensions in particular. In this article, we look at how interest rates work and what that can mean for investors.  
 

How interest rates work in the UK 

Interest rates play a key role in the economy, influencing a variety of financial products including savings, investments, pensions and property markets.  

Changes in interest rates are often a hot topic because of the effect they can have on things like our mortgages and savings. In the UK, the Bank of England reviews base rate eight times a year, with interest rate setting one of the tools the Bank uses to try to keep inflation in line with its 2% target.  

When inflation is considered too high, the Bank of England may increase base rate to help slow inflation as it makes borrowing more expensive and saving more rewarding. When inflation is too low, the Bank of England may lower base rate, which may help push inflation up as it makes saving less appealing and encourages people to spend more.  

Increases or decreases in base rate are often mirrored by commercial banks and building societies in relation to their mortgage and savings interest rates. 
 

What can a change in the interest rate mean for pension investors? 

Pension investors typically invest in a variety of financial assets, such as equities and bonds. Let’s look at how these can be affected by interest rates. 
 

Equities 

When investing in equities you’re essentially purchasing a share in a company’s earnings and ownership of its assets. The value of company shares depends on several factors including how well the company performs and how profitable it is.  

Changing interest rates can affect the borrowing costs of companies. If interest rates fall, their cost of borrowing may also fall, potentially leading to higher profits. This could impact their valuation and increase their share prices.  If you hold those shares, your return could be higher. On the flip side, higher interest rates may increase a company’s borrowing costs, possibly lowering their profits and potentially the value of their shares, so in that case, holding those shares could lead to lower returns on investment.  
 

Bonds  

Bonds are essentially a form of ‘I owe you’. With a bond, you’re lending money to a company (corporate bonds) or a government (UK government bonds are known as gilts). In return, they promise to pay you back later with interest. You can invest in individual bonds or bond funds, which are collections of many different bonds, with different interest rates and repayment times.  

Interest rates and bond prices normally have an inverse relationship. When interest rates go up, new bonds pay more money (higher interest), so fixed interest bonds already in the market that pay less become less attractive. This makes their prices go down. Conversely, when interest rates go down, new bonds pay less money, so existing fixed interest bonds that pay more become more attractive. This makes their prices go up. 
 

Making pensions more resilient 

Pension investors are usually invested in funds that typically contain a range of equities and bonds, and possibly other assets such as commercial property, for example. This diversification is designed to help spread risk and can help protect pensions in periods of volatility, including the effects of changes in interest rates. And, because pensions are invested for the long term, changes will typically be smoothed out over time.