Rising Interest Rates: An Opportunity to Act, not Time to React
When the COVID-19 crisis struck, authorities quickly took steps to alleviate the fallout. The U.S. Federal Reserve eased monetary policy and made ample liquidity available. Federal and state governments introduced measures to assist impacted individuals and businesses. As time wore on, uncertainty receded, markets rebounded, and the U.S. economy recovered from the initial shock.
More recently, investors have been focusing on the aftereffects of those unprecedented stimulus efforts, along with the challenges posed by global supply-chain disruptions and labor market pressures. After years of being subdued, inflation has been increasing, reaching its highest level in decades.1 Interest rates have risen in tandem amid indications that the Fed will tighten in response. Investors are growing increasingly concerned about how this might impact their stock and other investments.
The fallout from higher interest rates
Certainly, there are valid reasons for thinking that higher rates are negative for equities (and other riskier assets). For one thing, when risk-adjusted return prospects for one asset class appear to be improving, it naturally draws capital away from others, undercutting demand for the latter. High interest rates—or the perception they are on the upswing—boost the attractiveness of certificates of deposit, Treasury bills, and other short-term investments that can potentially generate decent returns with proportionally lower risk.
Additionally, interest-rate movements tend to have an outsized impact on the value of assets with long "durations"—the weighted average of the dates of future cash flows—whether that refers to the earnings from a business or the interest on a bond. Essentially, the higher rates are, the more that cash flow stream is discounted to calculate its present value. This is one reason why when rate expectations change, longer-maturity fixed-income securities tend to rise or fall at a correspondingly faster pace than shorter-term counterparts.2
That same notion lies at the heart of the discounted cash flow model many analysts use when valuing a business. It is also a reason why rising rates can undermine the relative attractiveness of “growth” stocks. All else being equal, “value” stocks—the shares of companies in stable industries that tend to generate predictable results over a relatively foreseeable period—will be seen as more valuable than those whose appeal rests on their longer-term prospects. The pressure from rising rates can be even more pronounced when expectations are overly optimistic.
Another factor to consider in the investment decision-making process
That said, history suggests that rising rates are not necessarily bad for equities, at least in the short run. As Bloomberg columnist Nir Kaissar noted in a Washington Post commentary, there is only a weak correlation between movements in interest rates and stock prices. In fact, he found that in the 13 U.S. Federal Reserve rate-raising campaigns that have occurred since 1954, the S&P 500 moved higher during 11 of them, with a median gain of 14%, excluding dividends.3
But this doesn’t mean you should ignore current developments. As with any factor that can potentially impact the business environment or supply and demand for various investments, they should be considered as part of the decision-making process. Rather than being viewed as a reason to react, the prospect of higher interest rates should be seen as an opportunity to assess whether your portfolios is aligned with your needs and requirements. Here are five strategies that can help in making this determination:
1. Ensure your portfolio and risk profile are in sync
One key to working towards long-term financial goals is understanding your risk tolerance and ensuring you’re positioned accordingly. Having a sizable allocation to equities can do wonders for performance when the going is good. However, the opposite holds true when things turn sour, which can be especially challenging if you lack the stomach or staying power to stick with it.
Research from Vanguard comparing the performance of portfolios with varying mixtures of fixed-income and equity exposure over 94 years reveals that while those that were 100% invested in stocks generated nearly twice the average annual return as those that held only fixed income securities, the former group also lost money in more than twice as many years, with the largest loss being nearly six times that of the more conservative portfolio.4
Given the above, you may want to consider creating a plan to reduce unwanted risk, including rebalancing asset-class allocations as necessary to ensure you remain on track.
2. Rethink your fixed-income exposure
When interest rates appear to be heading higher, perhaps in response to concerns about inflation, there may be tactical adjustments you can make that can help reduce the risk to your fixed-income exposure. Because rising rates have an outsized impact on longer-term issues, you may want to reduce the average maturity of bond holdings, if necessary.
Shifting allocations toward securities that tend to fare better in such an environment can be another way to mitigate risk. Examples include floating-rate bonds, which have coupons that keep pace with movements in rates, and securities that offer yield spreads over Treasuries—a "cushion” of sorts— including collateralized loan obligations (CLOs), mortgage bonds, and corporate bonds. Another option is inflation-linked bonds, which pay you more when goods and services prices are trending higher.
One area you may want to limit or avoid exposure to is the high-yield or “junk” bond sector. Highly leveraged companies and those experiencing financial difficulties can be adversely impacted when the cost of debt financing increases and economic and market conditions are less than sanguine. 5
3. Assess your portfolio’s stock allocations
As noted earlier, rising interest rates can shift the supply-and-demand dynamic in favor of value stocks. This group includes the shares of companies that offer more predictable earnings stream than those valued based on a potentially long and less certain future. It also includes so-called high-quality companies, which have strong balance sheets and the wherewithal to weather higher financing costs.
Aside from not having an uncomfortable level of exposure to growth stocks, another strategy that can help reduce equity-related risk when rates are increasing is to seek out investments with more attractive valuations or higher dividend yields. For example, international stocks may offer the best of both worlds because they are trading at lower valuations than US Stocks and may cushion some of the impact of a decline in equity prices.6
4. Consider expanding your portfolio’s assets
One way to dampen the impact of rising rates on stocks and bonds is to invest in assets that move to the beat of a different drummer. This might mean shifting public equity allocations to private equity investments offering the prospect of enhanced returns and reduced exposure to market-related pressures that can drive prices lower. Similarly, by investing in private credit funds, which, like banks, lend money directly to companies, you could potentially boost your fixed income return without assuming a consequently higher risk of default.
Other options include allocating funds to investments that can potentially benefit from or mitigate swings in volatility, or that can capitalize on trends in commodities or other markets. This includes managed futures, which often exhibit a performance profile that has little correlation to that of the more traditional asset classes.7 Another alternative is structured notes, which may offer the ability to capture the upside in stocks and bonds with a measure of downside protection.8
5. Maintain an adequate level of diversification
Whatever individual investments or asset classes you invest in, one key to working towards long-term financial goals is not putting all your eggs in one basket. In fact, odds are that when you are properly diversified, there will be some investments in your portfolio that are faring worse than others. Research clearly shows that diversification reduces risk and enhances long-term returns.9
Ensuring that your portfolio remains diversified does not mean, however, making drastic adjustments when allocations fall out of line with desired risk characteristics. By avoiding the urge to panic or take extreme actions—dumping bonds, stockpiling gold, or investing in derivatives you may not really understand—you can help minimize the downside risk of emotional investing and making what prove to be regrettable decisions.
Are you comfortable with the way your portfolio is positioned? If you’d like a second opinion please contact us at info@summithillwealth.com for a portfolio review and discussion of your risk tolerance with one of our Wealth Managers.
All written content is for information purposes only. Opinions expressed herein are solely those of Summit Hill Wealth Management, LLC and our editorial staff. Material presented is believed to be from reliable sources; however, we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual adviser prior to implementation. Advisory services are offered by Summit Hill Wealth Management, LLC a Registered Investment Advisor in the State of Colorado.
Sources
CNBC, “Inflation surges 7.5% on an annual basis, even more than expected and highest since 1982”
CNBC, “Here’s how rising interest rates may affect your bond portfolio in retirement”
The Washington Post, “Stocks Don’t Rise or Fall Because of Interest Rates”
Vanguard, “Portfolio allocations: Historical index risk/return (1926–2019)”
U.S. News, “When Corporate Bonds Are a Risky Investment”
Halo Investing, “Under the Hood: A Multi-Part Series on How Structured Notes Work”
CFA Societies Canada, “The Benefits of Diversification: How Diversification Reduces Risk and Enhances Compounded Returns”