If you’re keeping an eye on the rates that banks are paying on certificates of deposit (CDs), hoping to get a little more bang for your buck, you probably already know that interest rates are on the rise.
But what do you do with your entire investment portfolio when interest rates are rising? Navigating changing economic conditions is one of the reasons you may have hired a financial advisor. The trick is to take full advantage of rising interest rates without taking on extra risk.
How to Invest When Interest Rates Are Rising
First, let’s set the stage. Anyone with investments in stocks has enjoyed ten years of a raging bull market – the second-longest run in history. Now things are changing. We’re facing headwinds with high inflation and rising interest rates. The U.S. stock market has been in and out of correction territory with inflation running at 8.5% – the highest it’s been in 40 years.
At the same time, the economy is rapidly growing at a rate of 6.9% according to the US Bureau of Economic Analysis. Many economists argue that surging oil prices and geopolitical instability alone means GDP forecasts will likely be sharply revised as the underlying economy may not be as strong as it appears.
Understanding where we are in the current economic cycle is important because it provides a front row seat to the next interest rate hikes. The Fed regularly releases updates about its plans with interest rates, but it’s the actual economic data that drives the central bank's moves.
The question now is whether to reassess or reset your investment strategy – and to make that decision it’s critical to understand how your money is invested and whether your financial goals have changed.
How Rising Interest Rates Affect Stocks and Bonds, and Why You Should Care
Rising interest rates have a direct impact on most people, whether you’re an investor who owns stocks and bonds or you’re borrowing to buy a house. Higher interest rates means mortgages cost more and stock and bond prices tend to drop.
To stave off even more inflation, the Federal Reserve has already just raised short term interest rates by .25% and has signaled more increases to follow incrementally as needed. Now analysts are warning investors to expect lower stock prices the rest of this year as regulators continue to hike rates.
Interest rates and bond prices are also negatively correlated. Shorter-term bond prices are less sensitive to interest rate increases than long-term 30-year treasury bonds, so shorter durations are a much safer bet during times when interest rates are going up.
Now is a good time to take a close review of what's in your bond portfolio. If you have a financial advisor, discuss the possibility of selling some of the longer-term bonds, while picking up some with shorter maturities in order to limit or avoid potential losses.
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Fixed-Income Investors Tread Carefully
If you're in retirement or close to retirement, then fixed-income investments probably account for a majority of your portfolio. Rising interest rates could be a problem, depending on the mix of bonds in your portfolio.
A good investment advisor or financial planner should review your bond holdings to help you avoid bonds that will likely depreciate and to decide what, if anything, needs to be tweaked with your current strategy.
Here’s where that inverse relationship between interest rates and bond prices comes in. During times of rising interest rates, bonds with maturities of two to three years are a better (more stable) option because the shorter term bonds usually don't lose as much value as longer-term bonds.
You should ask your advisor two things:
- Are low-cost short-term bonds like the Vanguard Short-Term Investment Grade fund still a good option?
- Is it too late to consider Treasury Inflation Protected Securities (TIPS) because inflation has already spiked?
TIPS are a safe option when interest rates are rising because, although they come with a fixed interest rate, the principal on them increases as inflation increases. Inflation is one of the key measuring sticks used by the Fed right now, as regulators have directly tied their commentary on interest rate hikes with their inflation target. With TIPS, you'll continue to earn the same interest rate when you bought the bond, but after it matures, the principal you get back is higher because it's adjusted for inflation.
Positioning Your Portfolio for Rising Interest Rates
Remember, diversification wins all battles when it comes to investing. A balanced portfolio will still include some stocks, even during a time when they seem less attractive because the stock market may be correcting.
However, your advisor will tell you whether it’s a good time to readjust your stock holdings to target companies and sectors that will benefit from rising interest rates. Financial services stocks are often a good place to turn because when interest rates increase, banks make higher profits on the loans they produce.
Now is a great time to check in with your advisor and learn more about what is moving the markets and how you can keep your investments safe.
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