The days of record low interest rates may finally be nearing an end. Most economists predict (and the Fed has indicated) that an increase in short-term interest rates is all but certain for 2015.
How much of an increase and when it actually occurs will be based on labor market conditions, inflation indicators, and other financial developments. The better the economy does, the sooner and faster the Fed will increase rates – which follows the Fed’s recent decision to end quantitative easing, the bond-buying program that bolstered the economy and stimulated the stock market, which has risen about 131 percent.
Many investors wonder what impact rising interest rates will have on their portfolios and what strategies can best help them navigate a potentially volatile period.
“Investors, especially those seeking current income, need to consider not only the probability of rising rates but also the probability that rates, even if rising, could remain at historical lows for a long time,” says David Bruckman, managing director at Citrin Cooperman Wealth Management, a New York-based accounting firm.
There’s no one-size-fits-all answer, but here are some tips that can help you think about the best moves. Remember not to make any moves based on current headlines, but rather on a long-term strategy meant to withstand the market’s inherent ups and downs.
A rise in rates can do significant harm to bond assets, but advisors don’t recommend investors unload all of their bonds. Short duration bonds are less susceptible to interest rates moves, and high-quality tax-free municipal bonds might be a good move for more conservative investors.
Bruckman of Citrin Cooperman says that the rise in interest rates is less important if buyers of individual bonds plan to hold them to maturity. For investors who purchase bond funds, ETFs and actively managed mutual funds are a good solution.
For clients seeking current income, look for funds that focus on high-yield bonds, floating-rate notes, and international bonds. Short-term bond funds are a good hedge against the blow of potentially rising interest rates, Bruckman advises.
Another option: so-called unconstrained bond funds that allow managers the leeway to diversify positions in order to react to the market.
“For certain clients, treasury inflation protected securities (TIPS) should help over time to insulate a diversified portfolio against persistent rising rates, assuming such increases are accompanied by an increase in inflation,” says Bruckman.
Clare Sheridan, a former financial advisor at Morgan Stanley, says investors with a really strong conviction about rates going up might buy a floating-rate note: Its rate varies with market movement. She doesn’t believe that investors who want to generate income should be drastically changing their bond exposure.
“If you are trying to hedge against the stock market going down, then you’ll probably be in a longer-duration fixed-income bond,” Sheridan says. “If you just want to preserve capital, you’d be in a short, pretty safe, not very exciting investment.”
It’s more difficult to predict the impact increasing interest rates will have on equities, since so many factors influence how the market behaves. “The higher rates over the near term tend to have negative impact on the stock market, but if you look out at longer period of times, it’s actually a benefit,” says Michael Sabatino, managing director at McGraw-Hill Federal Credit Union.
When investors become frightened by the possibility of inflation, he says, that tends to create more market volatility — but in long-term cycles, owning stock is a way to protect against inflation.
Sarah Carlson, a private wealth manager at Fulcrum Financial Group in Spokane, Washington, recommends clients pursue high quality dividend-paying stocks. She’s looking at opportunities in health care and technology as bright spots that will continue to be sectors of what she calls American dominance.
If your stock holdings have grown disproportionately to the rest of your portfolio (they probably have), now might be a good time to take your profits and rebalance.
For those able to take on more risk, commodity trading and broad-based metals tend to rise with inflation and could serve as another hedge to rising rates.
Other potential alternative investments include master limited partnerships (MLPs), which are publically traded partnerships usually involved in real estate, petroleum and natural gas extraction businesses; absolute return funds, where managers have more discretion about the type of asset classes they can invest in; and real estate investment trusts (REITs). Investing a small portion of your portfolio in these investments could be a good move, but as always, check with a trusted advisor beforehand.
For retirees who need a fixed income, annuities may make sense and offer the peace of mind that comes with guaranteed income. “For older clients, an immediate annuity will offer considerably greater cash flow than that from a traditional fixed income portfolio,” Bruckman says.
CASH/MONEY MARKET/SAVINGS ACCOUNTS/CDs
After years of offering paltry returns, these old standbys could actually start to collect some interest. “Older folks who own CDs would benefit from the additional rate,” says Michael Sabatino of the McGraw-Hill Federal Credit Union. “It would be a positive for retirees generally who have these fixed income instruments which would generate more yield.”
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