The investment principle in the era of rising interest rates

During the last meeting of the Bank of Korea's Monetary and Financial Committee, the decision to increase the benchmark interest rate was not entirely unexpected, but it did arrive at the scheduled time. The interest rate was ultimately determined based on forecasts for growth rates and consumer price inflation. The bank raised its growth rate outlook from 2.6% to 3.3% for this year and maintained its outlook for consumer price inflation at 2.7%.

It also raised its outlook for growth in 2024 to 2.9%. Considering the growth rate being higher than the potential growth rate and the inflation outlook exceeding the target, the interest rate hike appears to be a well-considered choice. For investors, what should they focus on during the interest rate adjustment period? When choosing investment products, such as stocks and bonds, there are three key principles to keep in mind.

First, choosing investment products is important, but first, individuals must accurately assess their financial situation, especially their debt situation. Those with variable-rate loans should calculate how much their income burden will increase and, if it's too high, reduce their consumption or sell assets to control their debt burden.

Second, it's necessary to revisit the role of bonds in relation to an individual's investment horizon and risk tolerance. While many investors focus on the short-term returns of stocks, they often overlook the potential of bonds. However, with rising interest rates, the attractiveness of bonds increases while the attractiveness of stocks decreases.

Generally, interest rates serve as both the cost of borrowing and the discount rate used to calculate future profits. For example, the current value of 1 million won received in one year is over 950,000 won at a 5% annual interest rate but falls below 910,000 won at a 10% annual interest rate. However, bond investment should be approached through systematic purchases, and it's advisable to choose bonds that can be held until maturity based on one's financial situation.

Just like stock prices, interest rates are also challenging to predict accurately, as they are price variables. Particularly, long-term bonds that pay interest for a long time may experience temporary valuation losses when interest rates rise. If the bond has a low credit risk and can be held until maturity, the predetermined interest and principal can be recovered, but if it needs to be sold early, a loss may occur.

Finally, it's not advisable to concentrate all funds in bonds when interest rates rise. During the periods of interest rate hikes in 2017-2018 and since 2021, rising interest rates coincided with stock price adjustments, but in the prosperous years of 2005-2007 and after the financial crisis, stock indices rose even with interest rate adjustments.

An interest rate hike does raise borrowing costs and the discount rate, allowing some funds to be shifted into bonds. However, in the current context of proactively adjusting financial conditions considering growth, inflation, and financial stability, the impact on the stock market may be partially offset by improved corporate performance.

Another point to remember is that during periods of interest rate adjustments, it's essential to more strictly screen industries and companies in the stock market whose near-term profitability can be confirmed. This is because, during interest rate adjustment periods, the impact on the stock market from increased borrowing costs and higher discount rates for companies whose profits are realized in the distant future is significant.