Interest Rates and the Business Cycle
Fixed-income securities, such as bonds and preferred stocks, are particularly subject to interest rate risk. As we shall see in Chapter Two, bond prices generally fall as interest rates rise. This is because investors can purchase new bonds at higher interest rates. Previously issued bonds, which offer a lower rate, drop in price to remain marketable. Bonds with longer maturities are more vulnerable to interest rate risk than bonds with shorter maturities, because there is a greater chance of rising interest rates over the bonds’ longer life. Again, greater risk means greater reward.
Stock prices, too, can be vulnerable to interest rate fluctuations. A higher cost of borrowing due to rising interest rates causes both individuals and businesses to cut back spending. Less spending and investment means less production and worker layoffs. The threat of an economic contraction affects investors’ perceptions of future profits. Investors will begin to pull out of the stock market in anticipat
