With inflation at its highest in more than 40 years, the Bank of England are trying to bash it on its head with ever-rising interest rates, clobbering the rest of us in the process. The impact on mortgages many will be aware of, but how about other parts of the financial system. Will they affect stock markets, for example?! With higher rates looking unlikely to come off any time soon, we speak to three of the team at stockbroker AJ Bell: Laura Suter, head of personal finance; Tom Selby, head of retirement policy; and Russ Mould, investment director.
We cover:
- Cash savings
- Fixed term savings
- Credit cards
- Mortgages
- Pensions – annuities
- Pensions – defined benefit (DB)
- Shares
1. Cash savings
It seems strange to think that in December 2021, the Bank of England key interest rate was just 0.1%, and the best savings rate in the market was 0.65%. Now, the Bank’s key rate is 3%, and the best deal on the market for easy access cash is 2.85%. It means savers are being rewarded significantly more than they have ever since the onset of the Global Financial Crisis in 2008.
Laura Suter: “Savers are the big winners of a rising interest rate environment, as the Bank of England increases rates the interest rates offered on cash accounts will rise too. However, savers always have to shop around to get the best rates. If you leave you money in an old savings account, your bank might increase your rates slightly but you’ll be getting far less interest than the market-leading account.”
That said, it is worth noting that inflation – with its latest of reading of 11.1% – is still significantly higher than the rate of interest you will receive. This means your real rate of interest is actually negative! In other, the value your cash is still eroding. As such, don’t let the optics of rising savings rates fool you – it’s certainly worth looking at the stock market if you want to build long term wealth. Even in its current dire state!
2. Fixed term savings
These are savings account where you lock your money away for a certain amount of time in order to receive a higher rate of interest. With Bank of England rates rising, so do these. For example, currently, the best 1-year rate is 4.37% – much higher the easy access rate of 2.85%. A two-year fixed rate will get you 4.75%, a four-year 4.85%, and so on. See savings rates at Moneyfacts for the latest.
Laura adds: “Fixed rate savings accounts will usually pay you a higher interest rate than easy-access, as the bank will pay a premium in return for knowing that it will have your savings for longer. But if interest rates are still rising you need to be a bit cautious about locking away your savings, as you could miss out on future rate rises.”
3. Credit
Another set of rates that will rise with the Bank of England rate, however other factors also play a big part in consumer credit, including: “competition in the market or whether they want more of a certain type of borrower. For this reason, rates won’t rise directly in step with Base Rate.”
4. Mortgages
Mortgages are priced based on a number of different factors, including: “competition in the market but also the cost of the money mortgage companies borrow to then lend out to borrowers – whether that’s from savers’ deposits or the wholesale market.
“Anyone on tracker or variable rate mortgages will see their mortgage cost increase when base rate rises. This is because a tracker mortgage is designed to rise and fall in line with the Base Rate, with a premium on top. So, you might have a tracker of Base Rate plus 1%, meaning that if Base Rate is 2% you’ll be paying 3%. Once a Base Rate rise happens, these rates will often rise overnight to reflect that.
“A Standard Variable Rate (also called a reversion rate) is the highest rate from a mortgage lender and is what you’ll fall onto once your fixed rate deal is up. These generally go up as Base Rate rises, but not as quickly as with a tracker rate. The mortgage lender will decide whether to increase these rates and will give notice before they do.”
5. Pensions – annuities
Annuities are a guaranteed stream of income you can buy using money from your retirement pot. As the base rate has risen, so too has the rate on government bonds, known as gilts, which causes a knock-on effect to annuity rates.
Tom Selby puts some figures to it: “Annuity rates have increased by 40-50% this year, meaning for many people they will be a consideration today in a way they probably haven’t been for the past decade or so.
“To give you an idea of what you can get for your money, a £100,000 fund might buy a healthy 65-year-old a single-life, level annuity paying around £7,684 a year, according to MoneyHelper as at 25/10/22. However, anyone wanting inflation protection or to leave money behind to loved ones when they die will need to accept a significantly lower starting income.”
6. Pensions – defined benefit (DB)
DB or final salary pension schemes promise to pay a portion of your final salary until the day you die, although they are becoming an increasingly rare breed given their generosity. They are impacted by changes in gilt yields too, particularly recently when the disastrous mini-budget caused a very sharp sell-off.
Tom adds: “It’s important to emphasise that while DB pensions were caught up in this crisis, there was no direct threat to people’s retirement incomes. This is because it is the solvency of the employer that is the key factor when determining the strength of a DB promise.
“And even where an employer goes bust, the Pension Protection Fund (PPF) provides a valuable safety net, so members should still get back most of their promised pension.”
7. Shares
The impact of higher rates on stocks is perhaps the most complex but also the most interesting. Generally, when the rates we receive rise on the least risky option for our wealth – cash – then it knocks on up the chain of investible assets.
Russ Mould explains: “Any other alternative investment carries more risk so the investor should demand more from them – investment-grade corporate bonds should yield more than government bonds because companies can and do go bust, for example. The returns demanded by an investor to compensate themselves for the additional risks involved will therefore, in theory, move relative to the gilt yield.”
“If a central bank is raising interest rates, then the yield on existing government paper will look less attractive. Investors will sell them and look to buy newly-issued gilts, which will have to come with a higher yield to attract buyers. This increase in yields on government debt means the returns that investors should demand from other, riskier options, should also increase.”
For shares, this means investor will want higher returns. This means paying a lower valuation for the shares – which as an assessment of the share price relative to other things in the business, such as its sales or value of assets or profits – or receiving a higher dividend yield, which again is achieved by a lower share price. It is part of the reason stock markets have fallen this year.
But it more complex than that because certain parts of the market and certain companies are more sensitive to interest rate rises than others. In particular, those that are promising a lot of profits in the future and not today, for example, a plucky technology upstart. This is because analysts use interest rates to figure out what all that cash in the future is worth today. The higher the rate, the less it is worth today, and so the lower they value the stock.
Russ adds: “This may be why a lengthy period of low or even negative bond yields prompted a huge uplift in the valuation of perceived growth companies, such as tech and biotech stocks, during the past decade (and especially in 2020 to 2021). The problem now for holders of this sort of company is that the opposite effect is kicking in, at least for now.”