As many as a third of investors and advisors have never managed money in a rising rate environment. Many investors have spent much time contemplating the challenges the Federal Reserve’s long-awaited change in interest rate policy may bring. They have worried about how it would affect their investments and what is the best course of action when dealing with a rise in rates. But now that it has happened and with expectations that the next phase of Fed policy normalization will be rather modest, compared to previous rate-tightening cycles, advisors are recommending that investors come up with a well thought out plan for the future of their portfolios.
The Fed's Move
The Fed’s move to raise interest rates in December was far from unexpected, but it could mean that a new approach to investing is necessary. The move marked the first time it has raised rates since 2006. As of late December, many money managers believed that 2016 would be a good year for stock investors due to low interest rates, low energy costs and no inflation, resulting in higher earnings and growth in the economy. Whether it plays out like that is anyone's guess; the start of 2016 certainly has created cause for worry, however. (For more, see: Breaking Down the Federal Reserve's Dual Mandate.)
At the same time, policymakers have let on that future rate hikes will be gradual. Traders view the rate hike as a vote of confidence in the economy, which should be a good sign for corporate earnings expectations. In this new environment, advisors will be looking to help clients to make decisions about how to best preserve their assets, increase their income and reduce their income taxes.
For instance, some advisors are recommending that clients avoid taking on substantially more risk by implementing a combination of strategies. And while there is no way to totally avoid risk, when it comes to reducing exposure to higher interest rates, taking a diversified approach is often the best bet. (For more, see: How to Evaluate Your Clients' Capacity for Risk.)
Don’t Bail on Bonds
Bond prices and interest rates have an inverse relationship. As interest rates rise, bond prices fall. That means that longer maturity bonds are more vulnerable to rising rates because they could be locked into lower rates for a longer period of time. But while some investors see shorter-duration bonds as good solution to dealing with a rising rates, the flipside is that these shorter duration investments also over a lower yield. Some advisors are suggesting investors look at floating-rate securities such as bank loans and Treasury Inflation-Protected Securities (TIPS) that have adjustable interest rates, which make them less sensitive to interest rate increases.
Intermediate-term bonds are also doing surprisingly well during this rising-rate period, so advisors are warning their clients not to prematurely bail on all their bond funds just because they fear that rates are likely to rise again. With only a gradual rise in rates expected, accompanied by a flat yield curve and low longer-term rates, these bonds still offer some upside. In fact, many advisors expect intermediate bond funds to manage the next Fed tightening cycle quite well or even better than during some of the more aggressive rising-rate periods the markets have seen in the past. (For more, see: How Retirees Should Approach Interest Rate Hikes.)
Rising interest rates are typically a good thing because they mean that the economy is strengthening and credit risk is being rewarded. That’s why credit assets such as high-yield bonds and securitized loan portfolios are also a good option for reducing interest rate exposure, in favor of credit-risk exposure. Securitized credit typically does well without the addition of corporate exposure because credit risk is related to equity risk and can provide a firm foundation of higher-quality holdings, which is key if growth in the economy begins to slow down, many analysts believe. Below-investment-grade bonds are another option for risk takers, and can serve as a welcome addition to a portfolio during periods of rising interest rates. That’s because they offer high income during times of economic expansion.
Due to their lower interest-rate sensitivity, short-term bonds also can offer investors modest but dependable returns and great return-to-risk ratios. So some analysts are recommending unconstrained bond funds that have the flexibility to maintain an appropriate balance of credit and duration risk. In this way, they are able to weather periods of uncertainty and offer a low correlation to volatile equity markets. (For more, see: The Top 5 High Yield Bond Funds for 2016.)
Both unconstrained and short-term bond funds offer the benefit of lower interest-rate sensitivity while having the potential to earn higher yields for investors as rates rise. Overall, short and medium-term bonds will be less sensitive to rising rates in the current environment, so investors may want to reduce exposure to long-term bonds, advisors say.
In the current growth environment, investors looking for stocks should consider adding real estate investment trusts (REITs) to their portfolio, some consultants say. Because of their economic sensitivity, REITs have typically performed well in rising-rate environments, despite their volatility. So as the expectation of rising interest rates continues in 2016, investors may want to consider investment strategies that include all those asset classes that have performed well in rising-rate conditions.
The Bottom Line
Advisors and investors have known for a long time that a rise in interest rates was coming. That’s why it’s a good time for advisors to help their clients reassess their portfolios in order to make sure they are taking advantage of all there is to offer an improving economy. (For more, see: Why the Best Time for a Portfolio Risk Checkup is Now.)