Rates are on the rise: Do you have a strategy?

E*TRADE Securities2

06/07/18

Next week, the Federal Reserve’s Federal Open Market Committee is widely expected to raise interest rates by 25 basis points.1 If this happens, it would mark the second such rate hike in 2018. Because many financial institutions base lending rates on the benchmark federal funds rate, all manner of interest-bearing debt, from car loans to home mortgages, could be affected by the Fed’s decision.

So, what’s an investor to do about rising rates? Take a deep breath and read on.

Fed funds rate since 2016

Fixed income strategies for a rising interest rate environment

Let’s start with fixed income. Fixed income investors pay attention to rising interest rates because of the inverse relationship between bond prices and yields. Kind of like stress and time spent at the beach, bond prices fall as yields increase, and vice versa. This math is based on the fixed nature of bond coupon payments. Most bonds are issued with coupons at or near prevailing market rates. All else being equal, when interest rates rise, preexisting bonds yield less than newly issued bonds. This may cause older bonds to lose value.

Fortunately, investors have a number of choices in a rising rate environment. Bear in mind that some investors can find US bond markets somewhat difficult to navigate, making mutual funds and exchange-traded funds (ETFs) an easier way to gain fixed income exposure than buying individual bonds.

Here are a few examples of possible strategies, all of which are available in fund form:

Floating rate bonds

Floating rate bonds carry variable-rate coupons that rise and fall based on an underlying benchmark—typically, the three-month London Interbank Offered Rate (LIBOR). When rates rise, so do the coupons on floating rate bonds (although coupon changes are often subject to predetermined floors). The dynamic nature of floating rate bonds reduces their sensitivity to changes in interest rates, and helps them maintain value when interest rates rise.

Floating rate bonds usually come in two forms:

The first are senior bank loans, which are issued by companies with below-investment-grade credit ratings. That may sound risky, but true to their name, senior bank loans are senior to other debt in an issuer’s capital structure—meaning that senior loan investors are paid before unsecured bondholders in the event of default.

The second are fixed-to-float bonds, which come with a fixed coupon for a number of years before converting to variable-rate bonds with coupons that rise or fall as interest rates change. Not surprisingly, the closer the bonds get to the variable-rate portion of their life cycle, the less sensitive to interest rates they become.

Investors can access either of these strategies through mutual funds and ETFs, which some find more accessible and transparent than individual bonds.

Bond ladders

Bond ladders aren’t an investment vehicle, but represent a time-tested strategy. Don’t know where rates are headed? A bond laddering strategy attempts to hedge interest rate risk by establishing a ladder of bonds with varying maturities—say, from two to 10 years. If interest rates rise, the shorter-dated “rungs” of bonds can be reinvested at higher rates as they mature. If rates fall, investors have the advantage of holding longer-dated bonds with above-market coupons.

Bond ladders are appealing to investors who don’t want to predict the direction of interest rates. And for the superstitious who avoid ladders and black cats, we know of no one who has walked under a bond ladder yet.

Limited-maturity bonds

Of course, if investors are fairly certain rates are going to rise, they may wish to simply invest in high-quality short-term debt, including Treasury bills and commercial paper. Most look to money market mutual funds for this type of strategy. Don’t expect big returns from money market funds, though; inflation-adjusted return may even be negative.

Short-term paper comes with significantly lower yields than longer-dated bonds. Your choice of asset class will also affect returns. For example, Treasuries will usually provide lower yields than spread products like high-yield bonds and emerging market debt.

Sound complicated? Consider fixed income mutual funds or ETFs

It bears repeating: Individual bonds can be tricky to source going it alone. Investors interested in fixed income exposure may be better served by mutual funds or cost-efficient ETFs. The securities in these funds are traded by professionals at firms where performance matters.

Equity sector strategies

Equities aren’t as feature-rich as bonds, which can limit choices for positioning against rising rates. But certain sectors have historically outperformed in rising interest rate environments, so equity investors may opt instead for a sector-focused strategy.

Financials. Financial institutions stand to benefit from rising interest rates because net interest margins—the difference between what banks charge borrowers and what they pay to lenders—generally expand when rates go up. Higher interest rates may also signal a healthy economy and high levels of investment, which can be a boon for financials. But today’s conditions are unique. Because banks tend to lend long term and borrow short term, the recent flattening of the Treasury yield curve is actually squeezing net interest margins.

Industrials. For the same reason that financials can benefit from rising interest rates, industrials may be well-positioned for a rising rate environment. Interest rates often increase during periods of economic expansion, when industrial production is on the rise and factories are humming.

Consumer discretionary. If rising interest rates coincide with a growing economy, the well-heeled are more than likely opening their wallets on entertainment, automobiles, apparel, and leisure goods—all important components of the consumer discretionary sector.

As always, investment strategies should be aligned with an individual's risk tolerance, financial objectives, and time horizon.

Rising interest rates don’t have to be cause for alarm. With proper diversification, sound investment strategies can be practiced in any type of market. That doesn’t mean you have to love high interest rates. But an ounce of prevention is worth…well, you get the gist. Happy Fed watching.

 

1.  CME Group FedWatch Tool, June 7, 2018: http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

All bonds are subject to interest rate risk, and you may lose money.

The government guarantee relates only to the prompt payment of principal and interest and does not remove market risks. The value of these securities is subject to fluctuations prior to maturity.

Floating rate loans generally are subject to restrictions on resale and sometimes trade infrequently in the secondary market. Determining the value of a floating rate loan can be more difficult, and trading at an acceptable price can be difficult or delayed. Difficulty in selling a floating rate loan can result in a loss.