Markets & Strategies

4 Tips to Deal With Rising Interest Rates

The Fed is slowly raising interest rates. What now?

by Mark Cohen - October 30, 2017

Once upon a time, fixed income was considered the boring corner of the financial markets, and many investors were just fine with that. Each year, they’d cash in their 4% or 5% yield coupons and patiently wait for their principal to mature. The long bull market in bonds that started in the 1980s eventually cast the asset class in a more attractive light.

In December 2015, the Federal Reserve (Fed) raised interest rates for the first time in nine years, and has incrementally continued to raise rates thereafter. According to Brian Rehling, Chief Fixed Income Strategist with Wells Fargo Investment Institute, it’s as if the markets have entered a time machine.

After three decades of falling interest rates that saw bond prices (which generally go up when interest rates go down) at times match or outpace stocks, Rehling believes returns for 2018 may be in the lower single digit range, with most of that coming from yields, rather than price appreciation. “It’s back to a coupon-clipping market,” he says.

Things could be worse. For several years, observers worried how the markets would react to the first Fed rate hikes since 2006. For the most part, investors remained calm. The Bloomberg Barclays U.S. Aggregate Bond Index, which tracks the investment-grade fixed income universe, has seen positive total returns since the first rate hike in December 2015.

Brian Rehling, Chief Fixed Income Strategist with Wells Fargo Investment Institute, believes returns for 2018 may be in the lower single digit range.

Rehling foresees modest returns in 2018 for two reasons. First, the hikes now expected from the Fed should begin to lift yields. Second, because the rate increases are minor, they should only marginally depress prices.

Still, risks remain. And investors may need to readjust their expectations of the fixed-income market. Rehling suggests considering the following:

  • Go a little longer. Typically in a rising rate environment, investors are encouraged to shorten the maturity of their bonds. That’s because longer-term bonds tend to see their prices fluctuate more as interest rates move. However, now that it’s become clearer that a rapid string of steep hikes probably isn’t in the offing, Rehling suggests considering replacing some two- or five-year Treasury and corporate bonds with of those with slightly longer-term bonds as the shorter ones mature.
  • Get more with munis. Those in higher tax brackets who hold their bonds in taxable accounts may be able to eke out higher returns with tax-free municipal bonds. As of early September, the yield on 10-year AAA-rated general obligation bonds was 1.9%, 0.30% below comparable Treasuries. But once the tax advantages are included, the effective yield can rise to as much as 3% (depending on a state’s tax rate). Moving down a notch to AA-rated municipal bonds (AA-rated bonds are considered high quality with very low credit risk) may push that even higher. Of course, past performance is no guarantee of future results.
  • Diversify riskier sources of credit. Investors who need more income can still find potential ways to generate higher yield with a portion of their accounts. But they need to be careful, says Rehling. Rehling suggests sticking to the higher-quality end of the credit spectrum and spreading risk between high-yield fixed income and other sources of alternative income, such as emerging market bonds, Real Estate Investment Trusts, and preferred stock.
  • Take advantage of the tailwinds for stocks. Up to a point, higher interest rates may be good for stocks. “If you look at past cycles, equities have usually continued to do well for two to three years after the start of the rate hike cycle,” says Rehling. Low inflation and energy costs are among the other reasons Wells Fargo Investment Institute believes the bull market in equities may continue, favoring those sectors, such as consumer discretionary and technology that may stand to benefit most from a still-improving U.S. economy.

In other words, even if the fixed-income market “won’t blow your socks off” in 2018, says Rehling, there are still ways to stay on track toward your financial goals.

Mark Cohen is a freelance writer and financial services marketing consultant based in Brooklyn, New York.

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Risks:

Each asset class has its own risk and return characteristics. Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments.   Bonds are subject to market, interest rate, price, credit/default, call, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield fixed income securities are considered speculative, involve greater risk of default, and tend to be more volatile than investment grade fixed income securities. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. These bonds are subject to interest rate and credit/default risk and potentially the Alternative Minimum Tax. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer’s capital structure, subjecting them to a greater risk of non-payment than more senior securities. Foreign investing entails special risks including currency, political, economic, and market risks and different accounting standards. These risks are heightened in emerging markets. Real estate investments have special risks, including possible illiquidity of the underlying properties, credit risk, interest rate fluctuations, and the impact of varied economic conditions.

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