Investment Strategies to Help Weather Rising Interest Rates
Interest rates have been changing, driven by a number of factors including Federal Reserve policy, fiscal policy, exchange rates, economic conditions and expectations for inflation. After a long stretch near record lows, interest rates in the U.S. have started to rise as economic data has continued to support the Federal Reserve’s path of tightening monetary policy.
December 2016 marked the second time in a decade that the Fed had hiked interest rates. Since then, the Fed has hiked rates three times in 2017 and once so far in 2018. The Fed’s shift in policy, combined with other market factors, has resulted in the yield curve re-pricing and flattening over the past 12 to 18 months.
Anytime the markets are undergoing major changes like this, it’s a good idea to be proactive and examine your portfolio to understand the potential impacts of rising interest rates on your fixed income investments.
Why Does It Matter for Fixed Income?
Fixed income investments, like bonds and brokered CDs–certificates of deposits that can be bought and resold—are frequently perceived to be a low-risk investment. That isn’t necessarily the case and fixed income investments come with their own unique risks.
First off, every bond is always going to have interest rate risk, also known as market risk. When interest rates go up, bond prices fall, and vice versa. Interest rate risk arises from the potential that changes in interest rates, both in the U.S. and abroad, can reduce the market value of a bond you hold. Interest rate risk diminishes the closer it gets to the bond’s maturity.
This might not be an issue for investors that plan to hold the bonds to maturity, but it can still be a good idea to plan for the unexpected, or be more conservative if there’s a possibility you might need to sell before maturity.
Investors that decide to sell before maturity might have to sell at a lower price than they anticipated depending on how much interest rates have risen. Some bonds, like high-yield (“junk”) bonds and emerging-markets debt, have become more popular in the hunt for higher yields, but they can be more difficult to sell prior to maturity due to the potential of limited liquidity.
To get an idea of how much a bond will fluctuate, look at its duration, which is an approximate measure of a bond’s price sensitivity to changes in interest rates. The higher a bond’s duration, the more sensitive it will be to interest rate changes. All else equal, 1% change in interest rates will result in a 1% change of the price of the bond for each year of duration. If a bond has a duration of 6 years, a 1% rise in interest rates will result in a 6% decline in the price of the bond, whereas a 1% drop in interest rates will result in a 6% increase in the price of the bond.
Duration risk goes hand in hand with interest rate risk; the difference is that duration risk is specifically looking at the sensitivity of a bond’s price for every 1% change in interest rates.
Don’t Forget About Inflation
While interest rates are front and center when it comes to fixed income risks, inflation is another threat it is important to be mindful of. An increase in inflation, or just an increase in expectations of future inflation, typically results in a drop in bond prices, and vice versa, similar to the impact of interest rates.
The reason for this is because inflation erodes the purchasing power of future cash flows an investor expects to receive from the bond.
For example, let’s say you buy a 10-year bond that pays 3% interest and inflation is currently at 1.9%. Your nominal yield is at least higher than the rate of inflation, but after a few months, market conditions change and everybody is worried that inflation is going to be around 3.5% by the end of next year.
In most scenarios, no investor is going buy a bond where they’re losing money because inflation is higher than what they’re earning from the bond. In these cases, yields typically rise and bond prices fall to compensate for the change in inflation—or expected change.
The challenge with rising inflation compared to rising interest rates is that holding a longer-term bond until maturity might not be a viable strategy when inflation is climbing rapidly.
Time to Examine Your Portfolio?
Investors looking to mitigate interest rate risk, duration risk and the impact of inflation might benefit from shifting away from long-term bonds to shorter-term bonds, which typically experience less price volatility. Portfolio strategies like bond and CD laddering, where investors purchase several bonds or CDs with staggered maturity dates, is another strategy an investor might want to consider. Bond and CD ladders may help minimize some of the associated risks with these types of investments, while still providing a regular stream of cash flows.
Just because there’s a lot of uncertainty surrounding future interest rates doesn’t mean you should abandon fixed income altogether. Instead, take a closer look at your portfolio and slowly adjust your investments to a level of risk you’re comfortable with.
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