Interest rates are finally beginning to rise after decades of historically low rates, a development that if left unchecked can torpedo the investment portfolios and finances of the unprepared. But if you know what steps to take, you can contain the damage and keep your portfolio and your overall financial situation from taking on too much water.
As the economy continues to strengthen, the accomodative Fed policy of sustained low interest rates, which were designed to boost economic activity after the Great Recession of 2008, is likely coming to an end. Although we have had only two small rate increases in the last 10 years, the pace of rising rates is expected to pick up in 2017, with the Fed indicating upwards of three rate hikes this year. Rising interest rates can impact many areas of your life, from your investment portfolio to your overall financial situation. Here’s what to expect, and how to handle it:
Rising rates are generally bad news for your existing bond holdings
When interest rates rise, bond prices fall as investors holding bonds with lower yields are often unable to sell them for their full value when there are higher paying alternatives available.
You should review your current bond holdings to determine the potential damage as rates rise. A simple yet effective way to estimate the potential riskiness of your current bond investments is to review what is known as their duration. Duration measures the approximate price volatility of a bond or bond portfolio in relation to changes in interest rates. As an example, a bond portfolio with a duration of 10, would indicate that for a 1% change in interest rates either up or down, the value of the bonds will rise or fall by approximately 10%.
You read that right. if you own a bond fund or ETF with underlying holdings that are 10, 15, 20 years or more in duration, you could, in turn, lose 10, 15, or even 20% of the bonds value for every 1% rise in rates. If you own bonds with durations exceeding 2-3 years, you may want to consider re-allocating to shorter durations or consider looking at alternatives as discussed below. If you own an indidual bond and don’t plan on selling it anytime soon, you may consider holding it to maturity, but prepare yourself for a rough ride until then.
If you’re approaching retirement, reconsider loading up on bonds as a way to lighten up the risk in your retirement portfolio
Instead look at alternatives to traditional bond holdings in your portfolio. Consider floating rate funds, Inflation Protected Bonds also known as TIPS, and even laddered CD’s instead.
Even without looming interest rate increases, loading up on bonds as you approach retirement may not be a wise move. The traditional asset allocation thinking was that as you age, you need more stability in your portfolio to avoid potentially large losses from a steep market decline just before or during your retirement years.
The often cited ‘100 Minus Your Age’ rule of thumb states you should hold a percentage of stock in your portfolio equal to 100 minus your age, the balance in bonds or other relatively safe assets. As an example, a 60-year-old would have 60% of their assets in bonds, 40% in stocks.
This concept worked well when interest rates were much higher and as rates steadily declined from their peak in the 1980’s. As interest rates declined, the value of investors bond holdings increased, adding to their overall returns and attractiveness.
Unfortunately, the opposite is now likely to happen as alluded to above. The nearly 30-year bull market in bonds may be coming to a crashing halt. And that may not end well for many investors.
If you’re planning on financing a new or vacation home, now may be the time
Consider accelerating your purchase decision to avoid higher interest costs. That may be inconvenient if you haven’t decided on what to buy, but buying right after a series of rate increases causes regrets that can be calculated in real dollars — in the case of real estate, in significant amounts over time.
If you’re still paying off student loans, particularly if they are adjustable rate loans, now may be a good time to review your payment options
Unfortunately rapidly rising college tuition costs have led to record amounts of student loan debt. If you have an adjustable rate student loan, consider refinancing now and locking in today’s lower rates. If you have the means, try paying them off quicker before rising rates make it more difficult to do. It’s a good peace-of-mind builder regardless of what rates do.
Rising interest rates can also impact your stock holdings
The initial phase of rising rates can be good for stocks as they indicate an improving economy, but overall rising rates are not good longer term for stocks — particularly when rate increases are sudden or in rapid succession.
You can however take advantage interest rate changes by rotating into sectors that tend to do well in a rising rate environment such as Energy, Financials, Consumer Discretionary, Technology, Industrials, and Materials. As the market begins to cool when higher rates begin to take their toll, you may want to shift into more defensive sectors such as Utilities, Telecoms, Consumer Staples, REITS, and Healthcare.
By keeping up with news of Fed rate increases and monitoring rate trends in general, you can be prepared to make the necessary adjustments to your portfolio and keep rising interest rates from reducing the size of your nest egg.
Eric C. Jansen, ChFC, is the founder, president and chief investment officer of Finivi, which provides fee-only retirement-income planning and investment-management services for high net worth clients nationwide.
The information presented is not intended as financial advice, and you are encouraged to seek such advice from your financial advisor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Keep in mind investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money. Diversification/Asset Allocation does not ensure a profit or guarantee against loss.