Two ways to prep your ISA for rising interest rates

Inflation is the most recent fly investors just can’t seem to swat.

But amid all the chatter of inflation set to get out of hand, today’s UK consumer price index (CPI) reading has muddied the waters a bit. 

CPI came in at 2% for July against most expectations of 2.3%. Cue commentators donning their warpaint and asking what we were all worried about, and their opponents pointing to an ‘obvious’ blip on a ‘clear’ trajectory upwards.

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The inflation cat just landed among the pigeons.

Whether you believe it’s the calm before the storm or distinctly “transitory” (the word of the moment, especially among US central bankers) the past few inflation readings might at least serve as a sign to start thinking about how our portfolios could cope in a rising interest rate environment.

If inflation ushers in rate rises on both sides of the Atlantic, as central banks look to curb the effects of price rises, investors might have to get used to hikes not seen since before the financial crisis in 2008.

Here are two things to keep in mind for new stocks and shares ISA investors and those whose memories of rates above rock bottom are getting hazy.

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🤔 Deep dive: What is a stocks and shares ISA

1. Think about your asset mix 

Rising interest rates can take the shine off company shares as investors start to think about getting a return away from the stock market. Why take equity risk when you can get decent interest from cash or bonds?

Since the financial crisis prompted bankers to nail interest rates to the floor, income-seekers have leapfrogged cash and bonds in search of dividends. But with that search comes the added risk of the stock market.

A rising rate environment might be attractive to reluctant investors, only investing because their preferred options aren’t currently viable.

The thing is, record-low rates would need to rise quite a bit from here to offset the negative effects of inflation on your cash.

Inflation is constantly eroding the value of what you can buy with your money. As a result, even in a rising rate environment it’s not always immediately beneficial to switch to cash. 2% inflation takes a lot of the joy away from 0.5% interest.

And that’s skipping the point that inflation isn’t always terrible for stocks. It can even be a positive thing. In fact, equity valuations have tended to hold up well historically if inflation hangs around in the 2-4% range.

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Returns and inflation in year following first US interest rate rise

In short, if you’ve been equity-heavy for the past decade, it might be time to get used to thinking about how you’d bring bonds into your portfolio.

Long-dated bonds are more exposed to changes in interest rates, which means they have more to lose if rates rise as a result of higher inflation. 

The interest on offer from inflation-linked bonds is (you guessed it) linked to a rate of inflation, which means the income they pay out goes up if inflation does too.

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2. Diversify your stocks. Now.

Highly-valued US tech stocks took a wobble at the start of 2021 as investors started to think about what would happen if inflation started to take off.

Where did they go instead? Pretty much the opposite - lowly-valued UK stocks in economically sensitive sectors like banking, airlines and real estate.

Financials like insurance companies and UK banks got a lot of the initial attention. That’s because they make their money by offering us interest on savings accounts and then lending money out at higher rates, giving them a chunk in the middle to keep. 

Record low rates have seriously hurt banks’ ability to do this but if rates rise that could all change.

That’s a big ‘if’ though, and the uncertainty is reflected in how lowly-valued companies in the financial sector currently are.

Jumping head-first into these out of favour investment ideas can keep you up at night, waiting for the right conditions to lift your shares. 

But having no exposure at all could mean rising rates could do all the damage to your portfolio with none of the cushioning from value stocks. With certain sectors like tech still looking toppy it’s as important as ever to diversify, diversify, diversify.

Just be careful of how much debt these overlooked stocks have been racking up while they are in the stock market wilderness. A promising outlook could ultimately be marred by a huge debt pile preventing any real progress.

Commodity firms can raise their prices in line with inflation and pass it onto their customers and strong economic and job growth can support demand for commercial real estate. If you’re all in one one sector or geography after the past year, think about widening the pool.

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What's your take on inflation? Is it here to stay and how is your ISA positioned if it is? Let us know on the community forum:

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Building your wealth over the long term should help you create a more stable financial future. Open an ISA account or transfer from another ISA provider and make the most of your £20,000 annual ISA allowance. Alternatively, start your personal pension early by regularly contributing to a SIPP or moving old pensions to a single SIPP pension pot. Find out how to choose between an ISA and a SIPP. Download our iOS stock trading app or if you’re an Android user, download our Android stock trading app to get started investing.

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