Low interest rates are great, but even this silver lining has a cloud to it - those rates are eventually going to go up again. And when you really think about it, we should all be happy to see rates go up. Rising rates are a normal part of healthy economic growth and rock-bottom rates are usually a sign of a long-term malaise (like Japan) or bubbles in the making (like the U.S. housing market). With rates likely to head higher someday, what should investors do to prepare themselves?
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- Buy a House or a Car
If you have been thinking about buying a house, buying a car or refinancing an older mortgage (or a floating-rate mortgage with a lock about to expire), now might be the time. Although it is true that the interest rates for mortgages and car loans do not move in lock-step with the Federal Reserve's discount rate or the prevailing prime rate, they do all move together in general.
If rates move up 1% and you are looking at a 30-year loan for $175,000, that move can cost you about $40,000 over the life of the loan. That is certainly no small amount.
- Move to Shorter Bonds
As rates go up, the price of bonds goes down - but they do not all go down uniformly. There is a concept with bonds called duration, and it is a weighted measure of the length of time the bond will pay out, taking interest payments paid out into account. All other things being equal, a bond that matures in 10 years will have a longer duration than a bond maturing in five years. When rates go up, bonds with longer durations perform worse because these bonds' prices are more sensitive to interest rate changes.
What this means for investors is that they should try to move their bond holdings from long duration holdings to shorter duration holdings in anticipation of rising rates. (Learn more about duration in Advanced Bond Concepts: Duration.)
Consider Floating Rate Securities
One fixed-income option that could do relatively better for investors is floating-rate debt like adjustable bonds or leveraged loans. As the name suggests, the interest rates on these securities adjust to the prevailing interest rate and so as rates head higher, their interest payments go up in tandem. Keep in mind, though, that high-quality borrowers typically have no need for floating rate debt, so the credit quality on these bonds and loans is typically lower. The best way to protect yourself from that lower quality is to invest in a diversified portfolio, like a mutual fund, which is handled by a manager with a solid reputation.
One other word of caution - these floating-rate debt instruments are not the same thing as Treasury Inflation Protected Securities (TIPS). TIPS are bonds where the value is reset in response to movement in the government's measure of inflation. It is possible for rates to go up without much of an increase in official inflation, so make sure you understand the difference before you buy one or the other.
All investors should have a portion of their portfolio in foreign assets no matter what the interest rate environment. But when rates in your home market are looking as though they will move up, it is as good of a time as any to consider adding some foreign debt as well. Foreign bonds move in response to the rates and credit worthiness of the issuing country and can move up even while U.S. rates are on the rise. Here, too, though it is more prudent for investors to consider a well-diversified portfolio like those offered by ETFs and mutual funds.
What About Stocks?
There really is no one-size-fits-all rule regarding stocks in a rising interest rate environment. Generally speaking, though, past cycles indicate that sectors like industrials and information technology do better in rising rates. This makes sense if you think about it. Rates usually go up because the economy is growing again after a recession or flat period. During that preceding time, manufacturing activity typically slows and companies hold back on technology upgrades. So, when the economy recovers (and rates go up), it is not surprising to see industrials and IT rebound.
On the flip side, utilities and consumer staples tend to underperform during rising rates. I suspect that consumer staples underperform because they are seen as conservative, safer options for a tough economy and do not have the pop to attract investors when economic growth returns. With utilities, the argument is two-fold - first, these tend to be conservative investments (and so less attractive in economic rebounds), and they also tend to have very high ongoing debt needs, and so rising rates means higher interest costs for these companies. (Interest rates can have both positive and negative effects on U.S. stocks, bonds and inflation, check out How Interest Rates Affect The U.S. Markets.)
What Happens To Banks?
The banking sector is definitely going to see some turbulence as rates go up. Right now, banks have no particular need to loan money. They can borrow from the government or regular people (through deposits) at practically zero-interest rates and funnel that money straight into Treasuries. Earning less than 3% on Treasuries may not sound great, but when you buy them with ultra-cheap money it is a good, very safe spread.
When rates start going up, it is fair to assume that the interest rates on CDs, money market accounts and other deposits will go up. That is good for those who like to hold cash, but it means the banking sector's cost of funding will rise. That is not a positive, but look for most banks to offset it with increased lending activity.
The Bottom Line
Many market commentators have been made to look foolish by predicting imminent increases in interest rates. Eventually, though, they will be right. The alternative, a long stretch of Japan-style deflation, is something that very few people want. While rising rates are certainly a burden to borrowers, we have outlined a few ways that investors can position themselves today for that inevitable day when the Fed announces that the days of easy money are over.
Catch up on the latest financial news; read Water Cooler Finance: More Spilled Oil, Fewer Jobs.