How to adapt to rising interest rates

Over the past three decades, interest rates have steadily declined. Now that rates are finally rising, bond as well as equity investors should be wary of certain areas in the markets. Investors must be aware that rising interest-rate pain is not limited to long-term bonds. There are a number of sectors in your portfolio that can be negatively affected by rising interest rates.
Potential problem areas, along with why they have struggled lately include:
• Treasury Inflation-Protected Securities (TIPS) fell more than 7 percent. TIPS, like Treasuries with longer durations, suffered in a rising rate environment. In addition, tame inflation has further reduced demand for securities with built-in inflation protection.
• Emerging-market debt declined more than 9 percent. Emerging debt has been among the worst-performing bond assets as rates increased. Rising Treasury yields make riskier emerging-market bonds less attractive – the tighter yield spreads would no longer justify the added risk. Moreover, emerging-market local currencies have been depreciating against the U.S. dollar, which further dragged on bonds denominated in the currencies.
• Emerging-market stocks dropped more than 10 percent. Along with rising rates, emerging markets weakened on slowing growth in key markets, notably China and India, and the appreciating U.S. dollar.
• Utilities dipped more than 6 percent. Utilities typically suffer when bond yields rise as investors shift away from safe-haven, dividend stocks for better opportunities. Moreover, utilities have already experienced robust returns. In addition to so-so valuations, utilities are apt to remain rate-sensitive for the foreseeable future.
• Real estate investment trusts decreased more than 7 percent. REITs also suffer when bond yields rise. REITs rely on borrowing to run their business, so they are vulnerable to the level of interest rates. Additionally, REITs have been generating robust returns over the past five years and are beginning to look overvalued as yields diminished. Admittedly, investors accustomed to bond returns in a falling rate environment may find the results they can achieve as we transition to a new rate regime to be disappointingly low. Rising interest rates will likely be a headwind for bond performance for some time to come, taking a bite out of returns from coupon income. However, while other asset classes may offer greater potential for risk-adjusted returns in today’s market, bonds can and should remain core to investment portfolios due to its potential for income generation, diversification and capital preservation.
Fortunately, there are opportunities available for savvy investors to create resilient portfolios regardless of how far and fast rates may rise in the future. Even if interest rates continue to rise, keep in mind that the bond market is vast and diverse and different types of bonds respond to interest rate moves differently.
So how do we think and act to minimize the risks and maximize the benefits of transformational change?
• Reduce the average maturity of your bond portfolio. Shorter maturities allow for greater protection in an environment of rising rates and for reinvestment at potentially higher yields. Part of this strategy includes adding floating rate bonds and bank loans which have minimal interest-rate risk and can increase income in response to rising interest rates.
• Decrease TIPS allocation. Maybe the simplest way to reduce interest-rate risk in TIPS is to stay with TIPS but move into shorter-maturity securities. Shorter-maturity TIPS offer the same degree of inflation protection as longer TIPS with potentially much less downside risk from rising rates, in exchange for modestly lower coupon income. Also, if combined with CPI swaps to hedge inflation risk, the resulting portfolio could potentially provide much of the inflation protection of a pure TIPS portfolio with more after-tax income. • World-bond approach – Create a total-return-oriented strategy that invests in global bonds. This will add more flexibility to adjust holdings in pursuit of total returns in any interest-rate environment. Importantly, we believe the addition of global bonds helps to diversify a portfolio.
First, global bonds have historically had low correlation to US equities.
TIPS, and U.S. investment-grade bonds also represent a range of different markets with varying interest-rate cycles, rather than a single market and interest-rate cycle and have the potential to perform well in periods of weak economic growth, at which point their low correlation to stocks is important.
The past few months may well be remembered not only as the inflection point in the current interest-rate cycle, but also as a turning point in the three-decade bull market for bonds. Given numerous uncertainties that could potentially force unexpected changes in policy direction, we hesitate to unequivocally call the end of the secular bull market for bonds. Nevertheless, with the Fed’s policy intentions clarified by recent statements and speeches, we think the shift to a bear market for bonds may have occurred. We anticipate a measured and gradual normalization of U.S. monetary policy as the economy heals, and a commensurate rise in U.S. bond yields from today’s exceptionally low levels. •


Matthew M. Neyland is director of investments for SK Wealth Management in Providence.

No posts to display