Here's a look at the ups and downs of low interest rates and what they mean for physician investors.
Low interest rates are generally a good factor for increasing stock prices. There are at least two good reasons for this. First, companies can borrow to expand and grow with cheaper money, leaving more earnings and profit for shareholders (and potentially boosting stock prices). The second factor is that low interest rates push savers from fixed income into stocks. This generally increased money flow to stocks may also push up prices.
High interest rates offer an alternative to investing in the usually more volatile equities markets. If your bank CD is paying 1 percent, you will be more likely to take the "risk" of stocks than if you could earn a safe 5 percent to 6percent (as was the case just a few years ago).
However, low interest rates also cause many investors to "reach for yield." That is, they buy longer maturity bonds than they might otherwise purchase, therefore taking on significant risks in doing so. The investor often may not be aware they are doing so if they are buying fixed income inside a fund or exchange-traded fund. Investors may also buy fixed income that has less clear underlying security in order to get higher rates - investments such as foreign bonds, lower grade corporate bonds, and even mortgage-backed bonds in the recent past. So, generally low interest rates lead to investors taking more risk in both the stock and fixed income markets.
Consider what happens if interest rates move up. If they advance to mid-single-digit levels as was the case in the period between 2001 and 2008, stocks could still do well. The rates would not be so high that they would prevent companies from doing well. However, some types of fixed income could be devastated.
In general, with fixed income (bonds), prices vary inversely with interest rates. Higher rates drop the price of existing bonds; the longer the duration of the bond, the worse the effect. For example, a "safe" 20-year U.S. Treasury bond may drop in price as much as 15 percent for each 1-percent rise in long term rates. Investors holding these 20-year securities would lose five years of income (they are currently yielding under 3 percent) for every 1 percent rise in interest rates. As interest rates rise for high quality securities, the riskier ones look relatively less attractive, causing the value of these existing bonds to drop potentially even more than fixed income with better collateral.
During times of very low interest rates, investors should be especially cautious. I've mentioned the dangers of holding almost anything but reasonably high quality short-term domestic fixed income in times with a potential for rising rates. It may be reasonable to invest in non-U.S. fixed income instead to benefit from higher rates and a diversified currency effect. The prudent investor must assess the valuations and potentials of various global equity classes against each other before making an asset allocation. Investing remains a complex process with intense competition. Simple behavioral responses to low interest rates can be dangerous to your financial health.