Interest rates are on the rise and are expected to move higher for the foreseeable future.
If you are looking to make a major purchase – a house or car — you might be feeling some anxiety when you read this. If you are terribly risk averse and have all your money in CDs and savings accounts, though, you are probably breathing easier.
But what if you are significantly invested in the markets, working to build a nest egg for the future? What should you be feeling, and how should you respond to the rising rates?
Unfortunately, the answer (as it often is in investing) is… it depends. Different assets are affected in different ways by an ongoing increase in interest rates. We’ll take an in-depth look at how six popular investments are impacted. But first, let’s take our bearings so we know where we are in the investment and interest rate cycles.
The economy is in pretty good shape as measured by my CHIME index:
Consumer Spending – Continues to trend up. Consumers continue to lower their household debt.
Housing – Existing home sales are at their highest level in more than nine years.
Interest Rates – Money remains cheap despite increasing rates, and access to business loans is good.
Manufacturing – We are in expansion mode and well above where we were one year ago.
Employment – Unemployment is at a tolerable 4.8 percent.
Since the early 1900’s, stocks have moved in a series of long bull and bear cycles. The bull cycles run about 17 years, during which the market returns an average 14% annually. We are currently eight years into one of these bull cycles, according to the analysts. Bonds run in longer cycles of about 30 years. We appear to be nearing the end of a bull cycle for bonds. November 2016 was the worst month for bonds in 12 years.
Bond prices have been under pressure because interest rates are rising after 35 years of downward drift. The Federal Reserve expects that rates will continue to rise over the long term with the Federal Funds Rate moving from its current 0.63% to 2.88%.
The pace of the interest rate growth will also influence how different types of investments perform. If rates spike, like a kid’s energy after eating a king size Snickers bar, several asset categories might suffer. Gradual, moderate growth that indicates a healthy economy is what we all want to see.
Here’s how six common asset classes could be impacted by rising rates. I call this group B-CRISP – Bonds, Closed-End Funds, REITS, Income Commodities, Stocks and Preferred Stocks.
Bonds — Bonds move inversely with interest rates. During those 35 years of declining rates, bonds were thriving. But rising rates create a headwind for bond prices. This doesn’t mean you should avoid bonds. Quality bonds offer a nice income stream and low-risk protection against the volatility of the stock market.
Closed-End Funds — CEF’s have had a field day with the recent record-low interest rates. The cheap money has allowed the funds to boost their margin on high-return investments. Higher interest rates means higher capital costs for CEF’s. That might result in reduce distributions.
REITs – Real Estate Investment Trusts sell shares in a portfolio of real estate properties to investors. It’s a way to invest in real estate without worrying about clogged toilets. For the past 20 years, they have historically returned about 10.9% annually. While you might think REITs would take a serious hit from rising rates considering the higher cost on real estate borrowing, the reality of the economics behind REITs is so intricate it might not be the case. While REITs do suffer when rates spike, rising rates are a good thing in the long-term as they are often the result of economic growth and increased demand for residential and commercial property.
Income Commodities — Rising interest rates often signal a growing economy – one that will use more commodities. The inflation that comes with that growth can also drive commodity prices higher. MLPs, which allow investors to share in the profits from energy storage and transport systems can also benefit from the higher demand created by a growing economy.
Stocks — Rising interest rates are typically a good thing for equities – until they aren’t. Stocks tend to gain on rising rates until the 10-Year Treasury rate gets to about 4% – 5%. At that point, interest rates start to become a drag on the economy and, as a result, corporate earnings. Thus, stocks start to suffer. The 10-Year Treasury is currently around 2.4%, and corporate earnings are strong and are expected to remain so for the rest of 2017.
Preferred Stocks — Preferred stocks are a cross between a stock and a bond. They are issued at a par value and pay income in the form of dividends that may either be fixed or float. As a result, like bonds, preferred share prices are inversely tied to interest rates. As rates go up, preferred stock prices come down. A preferred stock with a fixed coupon rate that was set when interest rates were low might lose its appeal as rates rise.
Now that you understand what rising interest rates mean, how are you feeling about your investment portfolio?
Before you start brainstorming the changes you want to make, remember, if you have a well-crafted long-term investment strategy, you want to stay with that plan regardless of what’s happening with rates.
But it’s always a good idea to review your portfolio on a regular basis and tweak things accordingly. This would be a good time for just such a review.