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The Real Danger Investors Face with Rising Interest Rates

There’s a common question many investors are thinking about right now, and that is “What would stocks do when interest rates rise?”

Unfortunately, I think that’s the wrong question to ask. The better question, in my opinion, is this: “Would this company’s business be harmed if interest rates rise?”

The (non-existent) link between interest rates and stock prices

As I wrote earlier today in my article “How Would Stocks Perform When Interest Rates Rise? the theoretical view is that rising rates are bad for stock prices. But as I also showed in the article, stocks in the U.S. have actually climbed in 12 of the last 14 occasions when the Federal Reserve had raised rates.

It’s for a reason like this that investors shouldn’t be fretting over what stocks will do when rates rise because no one really knows – we’ve seen stocks both rise and fall in different occasions when interest rates have increased.

The (stronger) link between interest rates and businesses

Still, if you’re an investor in companies that have been borrowing heavily, the possibility of interest rates climbing (we’re in a low interest rate environment now, and that increases the odds that rates will be higher in the future) should concern you – but that’s only because rising rates have the potential to cause all kinds of financial difficulties for such companies.

Currently, the following shares are amongst the blue chips (excluding the banks) with the highest amount of borrowings as measured using the net-debt to equity ratio:

  1. Starhub Ltd (SGX: CC3); with a net-debt to equity ratio of 204%
  2. Olam International Ltd (SGX: O32); 183%
  3. Wilmar International Limited (SGX: F34); 85%
  4. Noble Group Limited (SGX: N21); 64%

Just because a company’s in the list above does not necessarily mean that it’s a bad investment or that its business is bound to suffer if interest rates start rising in the future.

But, investors in those four blue chips – as well as in any other company that has a high amount of debt – should still ask themselves some important questions to determine the likelihood and severity of any negative impacts which may come with higher rates.

Some of the important questions include (note that this is not an exhaustive list):

  1. How stable is the company’s revenue base? The existence of strong streams of recurring revenue gives a heavily-leveraged company a better ability to withstand the corrosive effects of more expensive debt.
  2. Does the company have a well-staggered debt-maturity profile? It’d be a lot easier for a company to handle the refinancing of its loans if it does not have to face a situation where huge chunks of debt come due within a narrow span of time.
  3. Do the company’s borrowings carry fixed or floating interest rates? If most of the company’s debt have floating rates, its profits and cash flows will be very susceptible to erosion from a rise in interest rates. On the other hand, if its borrowings are of the fixed rate variety, rising interest rates are of no concern – until the time comes when the company has to refinance its loans, that is.
  4. Does the company have strong cash flows? As the interest payments on debt are paid using cash, it naturally follows that a good defense against rising interest rates would be strong cash flows.

A Fool’s take

There are many investors who are worried about the dangers that rising interest rates can pose to stock prices; these investors are looking at the wrong issue. (Like I mentioned earlier, it’s tough to tell what would happen to stock prices if and when interest rates start climbing.)

The real danger is the effect that rising rates can potentially have on the businesses of companies, especially ones that have been borrowing heavily. Don’t lose sight of that.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.