Why Do Stocks Fall When Interest Rates Rise?
Last Updated on 4 seconds ago by Antony C.
Stock prices often fall when interest rates rise, even when the companies themselves are performing well.
One reason is that higher interest rates make safer investments, such as government bonds, more attractive. This changes how much investors are willing to pay for stocks.
Understanding this relationship can help investors make better sense of stock market movements.
Key Takeaways
- Higher interest rates make bonds more attractive, giving investors an alternative to stocks.
- Stock prices can fall even when companies are doing well because investors may no longer be willing to pay the same price.
- Companies with more debt, including some REITs, may face greater pressure from higher borrowing costs.
Disclaimer: I may or may not have invest in any of the stocks/REITs/ETFs, what’s listed here is only for entertainment purpose only and it should never be used as any form of investment advice. Past performance ≠ future results. While I’ve been investing for +15 years, I am still learning, this is my stock investment diary, and I wish to share what I learn during my investment journey so you may learn from both my success and mistakes. Enjoy!
How Rising Interest Rates Affect Stock Prices
Interest rates influence stock prices because investors are constantly comparing the potential returns and risks of different investments.
When interest rates change, the attractiveness of these investments can change too.
1. Higher Interest Rates Make Bonds More Attractive
When interest rates are low, government bonds generally offer lower yields. Investors seeking better returns may prefer stocks, even though they come with greater risks.
However, as interest rates rise, newly issued government bonds may start offering higher yields.
For example, a government bond that previously offered a 2% yield might be replaced by newly issued bonds offering 4%.
This creates more competition for stocks.
Investors who previously accepted the higher risks of owning stocks may now find government bonds more attractive. Some may even shift part of their investments from stocks into bonds.
When fewer investors are willing to buy a stock at its existing price, the share price may fall.
The company itself might not have changed. What has changed is the return investors can earn from other investments.
2. Investors Become Less Willing to Pay Higher Stock Prices
Higher interest rates can also change how investors value stocks.
A company may continue generating healthy profits, but its shares could become less attractive when safer investments offer better returns.
Example: How Higher Bond Yields Can Affect Stock Prices
Consider a company trading at $100 per share and paying an annual dividend of $4.
At this price, its dividend yield is 4%.
If government bonds offer only 2%, investors may find the stock attractive because of its higher income potential and the possibility of future share price growth.
However, if government bond yields increase to 4%, the stock may no longer appear as attractive at $100.
Some investors might only consider buying the stock at a lower price, such as $90.
| Before Rate Increase | After Rate Increase | |
|---|---|---|
| Government bond yield | 2% | 4% |
| Stock price | $100 | $90 |
| Annual dividend | $4 | $4 |
| Dividend yield | 4% | 4.44% |
This is a simplified example. The stock price and dividend are hypothetical, and actual market movements depend on many factors.
At $90, the dividend yield increases to approximately 4.44%, assuming the company maintains its $4 annual dividend.
The higher yield may make the stock more attractive to investors who are willing to accept its risks.
Of course, dividend yield is not the same as total investment return. Investors must also consider the company’s future earnings, dividend sustainability, and potential share price changes.
The key point is that a company’s share price can fall even when its business performance remains unchanged. Investors may simply be unwilling to pay the same price when other investments offer better returns.
Why Some Stocks Are More Affected by Rising Interest Rates
Although higher interest rates can affect the overall stock market, their impact varies between companies.
Businesses that rely heavily on borrowing may face greater financial pressure than those with little debt.
Higher Borrowing Costs Can Reduce Profits
Companies often borrow money to finance their operations, expand their businesses, or purchase assets.
When interest rates increase, borrowing becomes more expensive for companies taking out new loans or refinancing existing debt.
Higher interest expenses can reduce profits and leave less money available for business expansion or dividend payments.
However, companies with low debt or existing fixed-rate loans may be less affected, at least in the short term.
Why REITs Can Be More Sensitive to Interest Rates
Real Estate Investment Trusts (REITs) are a good example of investments that can be sensitive to rising interest rates.
REITs commonly borrow money to purchase income-producing properties, such as shopping malls, office buildings, and warehouses.
While these properties generate rental income, REITs must also pay interest on their borrowings.
Example: How Higher Interest Rates Affect a REIT
Suppose a REIT has $100 million in outstanding loans.
If its borrowing rate increases from 3% to 5%, its annual interest expense could increase from $3 million to $5 million, assuming the entire loan amount is affected.
That represents an additional $2 million in annual expenses.
Unless the REIT can offset these costs through higher rental income or other improvements, there may be less cash available for distribution to unitholders.
This is particularly relevant to dividend investors who depend on REIT distributions for passive income.
However, not every REIT will experience the same impact. Those with fixed-rate borrowings, manageable debt levels, and growing rental income may be better positioned to handle higher interest rates.
The important consideration is how rising borrowing costs affect each REIT’s financial performance and ability to maintain distributions.
Do Stocks Always Fall When Interest Rates Rise?
Although rising interest rates can put downward pressure on stock prices, stocks do not always fall when interest rates increase.
The relationship depends on several factors, including economic conditions, company earnings, debt levels, and investor expectations.
For example, interest rates sometimes rise because the economy is growing strongly. During such periods, businesses may also experience higher sales and profits.
Stronger earnings could help support share prices despite higher interest rates.
Similarly, a company with little debt and strong cash flow may be less affected by rising borrowing costs than one that relies heavily on loans.
Stock prices also reflect what investors expect to happen in the future. If an interest rate increase has already been widely anticipated, it may have little immediate effect on the market.
This is why the idea that rising interest rates always cause stocks to fall is an oversimplification.
Here’s What I think About Interest Rate
Higher interest rates can cause stock prices to fall because government bonds and other safer investments become more attractive. Investors may demand better potential returns from stocks, making them less willing to pay higher share prices.
At the same time, businesses with significant debt may face higher borrowing costs that affect their profits and dividends.
As a long-term dividend investor, I think it is important to distinguish between a falling share price caused by changing market expectations and one caused by problems within the company.
A lower stock price does not necessarily mean the business has become worse. Sometimes, it simply means investors are no longer willing to pay the same price.
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Antony C. is a Singaporean dividend investor focused on building passive income through REITs, ETFs, and Dividend Stocks. With 15+ years of experience investing in Singapore, Hong Kong, and China markets, he founded IncomeBuddies.com to share practical wealth-building strategies tested in his own portfolio since 2008. His expertise has been featured in Yahoo Finance, Nasdaq, and NFAA, and he’s the published book author of "Start Small, Dream Big".