The topic of rising interest rates has consumed the financial media. We do know the Federal Reserve has ended its easing policy and that an increase in the Federal funds rate will follow as soon as economic growth and the job market are on solid ground. Predictions on timing keep getting pushed out as we wait for the Fed to make its move. With timing so uncertain, how can investors properly align their portfolios?
As longer term interest rates rise it becomes more costly to purchase a home. Demand weakens and new home sales slow. This can trickle down to many other sectors of the economy, including businesses that supply materials for home construction and banks that see less loan activity.
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Borrowing Costs for Businesses Increase
Companies do plan and budget for higher borrowing costs, but if the rate of change is greater than expected it can cause businesses to put projects on hold, slowing growth for some companies.
Interest rates and bond prices move in opposite directions. Older bonds offer interest rates that are lower than prevailing market rates; therefore prices on these bonds fall so that the yield to maturity equals that of newly issued bonds sporting current (higher), interest rates. Duration is a measure of a bonds sensitivity to interest rate moves. In general a 1% rise in rates will cause roughly a 1% decline in the price of a bond. If you own a fixed income mutual fund the fund’s duration will provide a gauge as to how sensitive it is to rate moves.
The effect on the stock market can be varied because so many factors are at play. While it can be expected that economic growth will be strong enough for the markets to support higher rates, the market’s reaction is also influenced by expectations. A rate rise will certainly come as no surprise at this point, and a slow gradual rise in rates is likely priced in. Still, the anticipation of higher rates in itself brings volatility to the market. If interest rates move high enough that we see 5% rates on a CD for example, the risk-return dynamic changes as investors begin to reassess their desire to allocate as much to riskier assets such as stocks.
Investors should not react to headlines and rate predictions by reallocating stock and bond holdings. Investors are encouraged to stay the course and rebalance regularly. However, there are a few things to consider when determining whether your portfolio is set up properly given today’s rate environment.
Diversification is Key
Vary bond holdings across different sectors and maturities. Reduce exposure to those bonds maturing beyond ten years. Diversify your stock positions across sectors and add international exposure. International stocks typically outperform during a U.S. Fed tightening cycle. This applies to bonds as well. Global bonds are influenced by another set of economic conditions and global rates, and may not be impacted in the same way as U.S. debt.
Selling all your bonds in fear of falling prices is not the answer, but it would be wise to shorten the maturity of the portfolio to temper any price fluctuation. It is also likely that with bond yields so low, investors have added riskier assets to their fixed income portfolio to add more yield or moved into high dividend paying stocks. Now would be a good time to pare back that exposure and move into more traditional types of fixed income instruments with a maturity target inside of ten years.
Ladder Your Bond Holdings
Another approach is to ladder your fixed income holdings. A strategy similar to dollar cost averaging, an investor invests in the bond market slowly. Bonds are purchased with consecutive maturity dates so that a portion is maturing each year; this provides liquidity and the ability to reinvest at the current interest rates.
When rebalancing, focus on sectors that will benefit from higher rates such as financial and cyclical stocks. Earnings in the defensive sector are stable, so they can add some safety to the mix. That doesn’t mean to ignore the other sectors all together but to be prudent in looking for companies that offer value.
Note: Donna St. Amant, MBA, is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.
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The full-length version of this article is available at ptview.com.
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