If you’re keeping an eye on the rates banks are paying on certificates of deposit, hoping to get a little more bang for your buck, you probably already know that interest rates are indeed rising. But what do you do with your entire investment portfolio in an environment of rising rates? Navigating changing economic conditions are one of the reasons you may have hired a financial advisor. The trick is to take full advantage of rising interest rates without adding any extra risk.
What to do and when to do it?
First, let’s set the stage. We’re heading into the tenth year of a raging bull market in stocks—the second-longest run in the history of the market. The overall economy is growing at about 2.3% annually, and the Federal Reserve, which modulates short-term interest rates, is incrementally raising rates and, at the same time, expecting inflation to reach its targeted 2% level. Goldman Sachs economists say they see a 90% chance that the current economic expansion will set a new record as the longest in history, and in order to do that, the economy must keep expanding beyond July 2019.
Understanding where we are in the current economic cycle is important because it gives us a hint about where interest rates are heading next. The Fed regularly releases commentary about what it plans to do with interest rates, but it’s the actual economic data that really drives the central bank's moves. If the data doesn't turn out to be as rosy as what was expected, then the Fed will likely delay the next interest rate hike.
Higher interest rates mean lower stock, bond prices, and why you should care
Rising rates are critically important to 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. We saw the perfect example of this on February 8, when all the major stock indices lost almost 10% on the same day the Fed raised interest rates. Now analysts are warning investors to expect lower stock prices the rest of this year as regulators 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 might be a good time to take a good look at what’s in your bond portfolio, and if you have a financial advisor, discuss the possibility of selling some of the longer-term bonds and picking up some with shorter maturities in order to limit or avoid potential losses.
Fixed-income investors tread carefully
If you're in retirement or close to retirement, then fixed-income investments probably make up a good chunk of your portfolio. Rising interest rates can be a problem, depending on the mix of bonds in your portfolio. A good investment advisor or financial planner is going to review your bond holdings and help you avoid bonds that will likely lose value 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- or three-year maturities are a better (more stable) bet because the shorter term bonds usually don't lose as much value as longer-term bonds when rates increase. Ask your advisor two things: are low-cost short-term bond options like the Vanguard Short-Term Investment Grade fund a good option, and is now the time to consider Treasury Inflation Protected Securities? TIPS are another safer bet when interest rates are rising. These bonds are safer because, although they come with a fixed interest rate, the principal on them rises as inflation rises. 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
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 that will benefit from higher interest rates. Financial services stocks are often a good place to turn because when interest rates rise, banks make higher profits on the loans they make. This is a really good time to check with your advisor and at the same time, it’s an opportunity to learn more about what moves the markets and at the same time, keeps your investments safe.