Tue, 20 Sep 2016
A slow rise in interest rates likely won't have a massive negative impact on most investors' portfolios, says Morningstar's Christine Benz.
Jeremy Glaser: From Morningstar I'm Jeremy Glaser. With the Federal Reserve seeming set to raise rates at some point in 2016, many investors are starting to get nervous. I'm here with Christine Benz, she's our director of personal finance, to put any potential rate increases into perspective.
Christine, thanks for joining me.
Christine Benz: Jeremy, great to be here.
Glaser: So you said the first thing that you should really keep in mind about any potential rate hikes is not to panic. That this isn't going to be--and maybe we already saw this with the rate hike last December--isn't going to be some sort of cataclysmic event.
Benz: That's right, I don't think anyone is forecasting some sort of stratospheric increase in interest rates. Let's face it--the economic data has been pretty mixed, which I think is why the Fed has moved pretty deliberately here, hasn't taken aggressive action to increase rates, that they are still watching and they're still mindful of the risk of disrupting a recovery that isn't all that terribly strong. So, if we do see some rate changes here between now and year end, I think it would be unlikely that we would see a very large increase. Nonetheless I still think it's worth thinking about how rate increase might affect your portfolio.
Glaser: And if they do raise rates, that's probably a reasonable sign that the economy is picking up steam, where they see kind of that steady state continuing.
Benz: That's right, I think as investors we tend to naturally focus on our portfolios and how our portfolios might behave in a rate increase. But the fact is, if rates were to stay as low as they have been in perpetuity that would send a pretty negative signal about the health of the economy. A healthy economy does have some inflation for example. And so if the Fed were to stand back, not act because inflation is nonexistent, it would generally be reflective of pretty weak economic conditions which we don't want to continue.
Glaser: So we'll talk a little bit about how rate increases could negatively affect your portfolio. But for a lot of investors this actually probably is a positive sign, particularly for savers.
Benz: That's right. The Fed's policy has been, I think rightly called a war on savers, that you've had people having to make do on lower and lower yields over the past decade really or more. So, one advantage, one sort of silver lining in a rate increase is that you do start to see higher yields come online. That's good news for people in safe investments, in cash investments, certainly they should be able to begin picking up higher yields. But it also is something that bond investors can take advantage of. Yes, they do see that short-term price hit when rate increases come about, but they are able to pick up higher yields as they become available. So it's not a universal negative for portfolios by any stretch.
Glaser: Does it make sense then just to kind of park everything in cash and wait for those rates to go up right now?
Benz: Well, that's certainly been something I've been hearing about, a strategy I have been hearing about from investors, but I will say that I've been hearing it for the past seven years. Where some investors have said, gosh rates are going to have to go up sooner than later, might as well just hunker down in cash, wait for this whole thing to blow over, and then start getting back into bonds. The big problem with that though--as we've seen for investors who have embarked on that strategy--is that there is a big opportunity cost to holding cash. The poor cash investor has had to make do on a lower and lower yield, whereas bond investors, yes they too have had to make do with lower yields, but they've been able to partake of some of that price appreciation as bond prices have increased.
So it's tough to say that there's a lot of room left for bond prices to increase, but nonetheless there is an opportunity cost. That's why I think it usually makes sense for investors to think about their time horizon for the money in question. So certainly if you have money that you expect to need to spend within the next couple of years, hold it in cash, you are not getting paid to edge out on the risk spectrum into bonds for short-term assets like that. But if you do have a somewhat longer time horizon I think it's reasonable to start thinking about some sort of a short-term, high-quality bond product. Yes, you might feel a little pain if interest rates go up, but you should be able to pick up a higher yield over time. And certainly if your time horizon is more in the neighborhood of five years you should be thinking about some sort of an intermediate-term product where yes, you'll have even more interest rate related volatility, but also the potential for higher yields.
Glaser: But even if you think that for investors who have a long time horizon should stay in bonds it might not necessarily be a smooth ride as increases hit.
Benz: Right, that's right. So even though as interest rates hit and some higher-yielding bonds come online, investors do see their price negatively or will see the prices of their bonds negatively affected during this time period. So one strategy, one stress test that I have been urging investors to go through is find bond--say they have bond funds in their holding--find the duration of that product, find the SEC yield of that product. Duration is a measure of interest-rate sensitivity, subtract the SEC yield from the duration, the amount that you are left over with is roughly the amount that you could expect to see that product loose in a one-year period in which interest rates went up by one percentage point, which is a much bigger move than anyone's expecting, but nonetheless something to think about.
So say you have some sort of an intermediate-term fund in your portfolio today. Maybe it has a duration of four and half years and its yield, it's SEC yield is 2%. So that would be a roughly 2.5% loss on that product in that one-year period in which rates went up by one percentage point. Definitely not welcome for the safe part of your portfolio. But my guess is for most investors, probably not as bad as they envisioned when they thought about the implications of rising rates on their fixed-income portfolios.
Glaser: You were just talking about core bond funds. We think of government bond funds as being particularly susceptible to interest-rate increases. What other categories do you think are very exposed kind of levered to potential changes in interest rates?
Benz: Well that's a good point Jeremy. Before we leave this duration stress test idea, I want to point out that it will tend to be most useful for kind of that high-quality portfolio, that high-quality fund in your portfolio. It will be less useful for some of the noncore fixed-income types, such as high-yield bonds, emerging-markets bonds, and so forth.
But I think you raised a really valuable question, which is, yes, government bonds are usually the most susceptible when we have interest-rate changes for better or for worse. And the key reason is that government bonds are perceived to have no credit risk. So it's fairly easy to gauge the impact that interest-rate changes will have on their performance and on their prices.
With other bond types it's not as clear cut. But I would say that perhaps given that we've seen yields across the board so compressed that perhaps there is a little less margin for error with say junk bond portfolios, than perhaps there was even a year ago. So one thing we've seen on junk bonds, for example, is that the spread between Treasury yields and junk bond yields has compressed to like five percentage points today, whereas it was eight percentage points earlier this year. So that means that from a practical standpoint high-yield bonds have less of a cushion against these price changes than they once did. Their yields simply aren't as high, and I was talking to our colleague Eric Jacobson about this this morning.
In real terms, these businesses that turn to the debt markets to finance their business operations tend to get hit in these periods of rising rates. A lot of high-yield debt issuance is pretty short term, and so that means that a company issuing this type of debt is likely going to have to go back to the markets, perhaps pay an even higher-priced to service that debt than they did before. So he points out that it's a real headwind from a business standpoint when yields go up, that it does affect some of these highly leveraged companies. So high-yield bond funds would be a category that I would say, yes, they may move less than government bond funds in such an environment, but they won't be impervious.
TIPS are another category. I think investors may have heard about, well, Treasury inflation-protected securities, or TIPS, help shield you against inflation risk. Well they don't shield you against interest-rate risk. In fact, oftentimes we see those things moving in the same direction where you've got the TIPS fund that gives you the inflation adjustment at your principal level, while at the same time you are incurring a little bit of price depreciation when interest rates are increasing, and of course interest rates are often increasing when inflation is moving up. So that's another category to keep an eye on. That's one reason why I have recommended for investors with shorter time horizons that they think about some sort of a short-term TIPS product because it tends to carry less interest-rate-related volatility. The durations on some of the core TIPS products are long like eight years. So you need to be careful there certainly if you have near term income needs, you'll see a lot of price volatility on some of those core TIPS products.
And finally I would say any equity type, where investors are looking to it to be sort of a bond substitute, I think we'll see some price related volatility in a period of rising rates. So utilities, REITs, some of the consumer staples stocks with healthy dividends, some of the pharma names with healthy dividends. But particularly those types of firms where the dividend is one of the main attractions for investors owning it. There is not a growth story, there is not a reason to expect that there will be a lot of capital appreciation. I would expect when we start to see higher yields come online that some investors will say, well if I can get a safer yield over here in bonds, I may not want to be in this equity. So I think we'll probably see a little downward pressure on some of those high income producing equities.
Glaser: Christine, thanks for your perspective today.
Benz: Thank you Jeremy.
Glaser: From Morningstar, I'm Jeremy Glaser. Thanks for watching.