An interest rateInterest rate A fee you pay to borrow money. Or, a fee you get to lend it. Often shown as an annual percentage rate, like 5%. Examples: If you get a loan, you pay interest. If you buy a GIC, the bank pays you interest. It uses your money until you need it back.+ read full definition is the amount a lenderLender Any person or organization that lends money.+ read full definition charges as a percentage of the total amount borrowed. It’s usually expressed as the annual percentage rate (APR)Annual percentage rate (APR) The total costs of a loan or other debt each year. It is stated as a percentage (for example, 5%). Use it to compare your borrowing options (for example on a mortgage or credit card)+ read full definition. Most of us understand how interest rates work for mortgages and other loans, but let’s take a look at how interest rates affect how we investInvest To use money for the purpose of making more money by making an investment. Often involves risk.+ read full definition our money.
The role of the Bank of Canada
One of the Bank of CanadaBank of Canada The central bank that sets Canada’s money policies. These policies help keep the Canadian dollar stable. They also affect our economy and our money supply. The goal of the Bank of Canada is to keep currency and the financial system stable. They are the sole authority to issue banknotes – bills.+ read full definition’s roles in the financial system is to promote the economic and financial welfare of Canada. The Bank of Canada has many tools to help it achieve its objectives, including influencing short-term interest rates by raising or lowering the overnight target rate The overnight target rate is the interest rate that financial institutions use to borrow funds from each other.
When the overnight rate changes, there is a ripple effect that impacts other interest rates. This causes a change in the demand for goods and services, how people and businesses borrow and spend money, and the types of investments purchased.
The Bank of Canada has an inflationInflation A rise in the cost of goods and services over a set period of time. This means a dollar can buy fewer goods over time. In most cases, inflation is measured by the Consumer Price Index.+ read full definition target of 2%, within an inflation-control target range of 1–3%. To stay within that range, the Bank of Canada raises or lowers the interest rate.
While changes in the target for the overnight rate can influence interest rates, it’s not the only factor that affects the rates set by financial institutions. They set their rates based on the markets, the cost of money borrowed by other financial institutions, and the creditworthiness of their own customers.
High interest rates vs low interest rates
Higher interest rates generally limit the amount of money people can afford to borrow and may even discourage some people from borrowing at all. The interest rate is the cost of borrowing.
The stock marketStock market The collection of markets and exchanges where stocks, bonds and other securities are issued or traded.+ read full definition tends to fall when interest rates rise as companies are negatively affected by the higher cost of borrowing and are dealing with decreasing consumer demand which can dampen their earningsEarnings For companies, it’s the money they make and share with their shareholders. For investors, it’s the money they make from their investments.+ read full definition and lower their stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition prices.
Interest rates and bonds
Interest rates and bondBond A kind of loan you make to the government or a company. They use the money to run their operations. In turn, you get back a set amount of interest once or twice a year. If you hold bonds until the maturity date, you will get all your money back as well. If you sell…+ read full definition prices move in opposite directions. Generally, if interest rates decrease, bond prices increase and if interest rates increase, bond prices decrease.
A fixed-rate bond is more attractive to investors in a decreasing interest rate environment. For example, a bond with a fixed rate of 7% will generally become more valuable if interest rates decrease to 6% from 8%.
A fixed-rate bond is less attractive to investors in an increasing interest rate environment. For example, a bond with a fixed rate of 7% will generally become less valuable if interest rates increase to 8% from 6%.
When to sell your stocks and invest in bonds
There is no one-size-fits-all approach to this decision as individual goals and circumstances differ drastically from one investor to the next. We recommend speaking with your financial advisor before making decisions on altering your asset mixAsset mix The percentage distribution of assets in a portfolio among the three major asset classes: cash and cash equivalents, fixed income and equities.+ read full definition that may impact your long-term investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition returns.
Learn more about how to assess risk in the bond market here.