Should my investment portfolio stay the course of assuming rising interest rates in 2017?
Since the end of last year, there has been talk of the Fed's intention to raise interest rates. I have adjusted my portfolio and investment strategy under the impression that rates will rise this year. However, the Fed has kept rates steady thus far and have been inconsistent in their goals. What are they waiting for? Should I hold steady and continue to invest as if rates will rise in the near future?
The conventional wisdom suggests as interest rates go up, bond prices go down. The issue is, we have no way of knowing how long interest rates will remain at current levels or more importantly, if the Federal Reserve’s actions will be give way to a more normal interest rate environment. If history is any indication of their ability to police interest rates, the chances aren’t good. Since 1980, we’ve seen rates ranging from the highs of 20% to lows of .5%. Given that large level of fluctuation, it’s hard to argue that they have the ability to hold sway over a normal environment through their actions.
The questions are a bit more relevant to your time horizon for using the funds. Knowing that all these things are uncertain, the best ways to potentially insulate yourself for the long term is by maintaining a consistent strategy from the beginning. Bond mutual funds or ETFs that have durations longer than 5 or 10 years are likely to fluctuate more during rising interest rate environments. The same holds true with those that have credit ratings below investment grade. Fixed income is an important asset class to the majority of portfolios, in most cases, as a vehicle to insulate you from equity market risk, which historically should provide a higher expected rate of return. Therefore, I’m a bigger advocate of long term investors assuming risk where historically, they have been more rewarded for it, and not taking on too much interest rate and credit quality risk with the fixed income part of their portfolios.
It depends on your time frame. There is no question that the risk profile of bonds have increased over the past 6 months. They have sold off by about -3% to -6%, depending on the sector beginning early last fall. This year, they have had a little bounce and seemed to have stabilized. Now, whether this is a "dead cat bounce," meaning a lull before heading lower, is the million dollar question.
But the amount of upside gains doesn't outweigh the amount of downside in my opinion. Especially over the longer term. So to the extent you want bonds, I would use Exchange Traded Bond Funds (ETFs). This way, you could easily exit without any difficulty very quickly if you saw rates beginning to rise with any intensity.
And currently, dividend stocks are more attractive than bonds, especially with their current yields. I am an active manager and my answer could change fairly quickly if the economy deteriorated for any reason. But at the moment, I think your thinking is spot on. One of the hardest things to do as an investor is to be patient. A few weeks or even a few months seems like an eternity to people, but to the investment cycle and the markets, it is a very short time frame.
Hope this helps, Dan Stewart CFA®
Great question! Rising rates are a very popular theme nowadays, and the Fed has indicated they will target successive rate hikes this year. That being said, there are many things under consideration that could take that off track, from political headwinds to global economic events. If you're comfortable with not receiving the higher income associated with longer maturity bonds for the next few years, and investing in very short-term bonds for as long as this rate cycle takes to get back to somewhat normalized rates, then your patience may be rewarded. But, it is anyone's guess as to how quickly and the magnitude of interest rate increases in the near-term.
Ever since the Federal Funds rate dropped to 0.0 - 0.25 in 2008, investors have been worried about the eventual increase in the rate and the decrease in bond prices. Some argue that the expectation of these increases has already largely been factored into the price of bonds and rate hikes in the future won't have such great of an impact as most think. We're in a 8 year bull market and 7 years out of the recession. Rates are still historically low and as long as the economy is improving, it seems the Federal Reserve will raise the Federal Funds rate, but very cautiously and slowly. Just like nobody can consistently predict what the stock market will do from year-to-year, nobody can consistently predict the health/strength/certainty of our economy which is directly correlated with the raising of the Federal Funds rates. Especially with a new presidency that has a completely different economic policy than the previous 8 years, who knows where the economy will be now or in a few years from now.
With where rates are now, it only makes sense to keep maturity and duration of your bond holdings relatively low, but I caution against becoming extreme (going COMPLETELY to cash or short-term treasuries). Giving a specific recommendation is impossible without knowing your financial situation, risk tolerance/capacity, and the amount of time before you use your accounts for income. As always, the best antidote to future uncertainty is having a diversified portfolio with bonds or bond funds representing different markets and maturities.