Is Your Portfolio Ready for (More) Rising Interest Rates?

The Federal Reserve increased interest rates by three fourths of a percent when it met last week. As inflation has yet to cool down, the Fed also announced its intention to pursue further rate hikes during the remainder of the year.

The bond market isn't waiting around. The 10-year Treasury yield passed 3.5% last week for the first time since 2011, up from just 1.2% in the summer of 2021. And bond prices have dropped accordingly. The Bloomberg U.S. Aggregate Bond Index has dropped over 12% so far this year, and longer-term bonds have dropped further still. Long-term Treasuries, for example, have shed about 25% for the year to date through Sept. 21, 2022, on top of a 5% drop last year.

The question is, what, if anything, should you do to prepare your portfolio for rising interest rates? A good bit of the Fed's likely activity is already priced into stocks and bonds, and it's rarely a good idea to be too reactive or to position your portfolio for all-or-nothing scenarios. Interest rates could climb sharply in the years ahead, or they could flatline or even reverse course if the economy slows and/or the Fed's rate increases have their desired effect of taming inflation.

At the same time, you also want to be prepared. Growth stocks and long-term bonds have all lost value recently, but over the long term they've benefited from the fact that interest rates have remained low for decades. Given that many investors are inclined to be hands-off with their portfolios, it's possible that they're heavy on the very market segments that have been getting clocked recently.

The goal is to strike a balance: Even as some of your holdings may experience losses in the face of interest-rate changes, others may be beneficiaries. As you survey how your portfolio might respond in a rising-interest-rate environment, here are the key items to keep on your dashboard.

Bonds: A Duration Check

High-quality bond prices tend to respond immediately, and negatively, to anticipated interest-rate changes. Thus, they're a logical first stop if you're assessing how your portfolio is apt to behave in a rising-rate environment.

To help address the vulnerability of your bond-fund holdings when rates go up, I recommend the duration stress test I wrote about earlier this year. Your fund's duration minus its SEC yield is roughly the amount you would expect it to lose in a one-year period in which interest rates jumped by 1 percentage point. As the Fed has hiked interest rates by 3 percentage points this year, it's no wonder that many intermediate- and long-term funds have lost multiples of their durations so far this year.

As you conduct this exercise, bear in mind that your funds' returns are already reflecting the bond market's best guess about the Fed's likely actions. If and when the Fed moves to lift interest rates, your holdings won't necessarily experience another set of large price declines on top of the losses they've already racked up.

For that reason, it's probably not a great idea to dump all of your intermediate-term bond holdings in favor of short-term, or switch from bonds to cash. Simply put, you're probably too late, and doing so would be akin to saying that you know better than the bond market about what might happen with interest rates from here. Moreover, starting yields are a good approximation of what you're likely to earn from bonds over the next decade: Because of their higher starting yields, intermediate-term bonds are likely to earn more than short-term bonds, and short-term bonds more than cash.

But the duration stress test is a way to ensure that you understand the volatility your your holdings could face in a rising-rate environment and that your time horizon is appropriate given the potential for short-term losses. For near-term cash outlays—money for your bills during retirement over the next year or two, next semester's tuition payment, or a new roof you may need tomorrow—there's only one asset class that reliably stays positive (at least on a before-inflation basis): cash. That's why my bucket portfolios include a persistent allocation to cash, even though it's a drag on returns in upward-trending markets. It's not often that bonds lose money at the same time stocks do, but rising interest rates make that scenario more likely. Cash is there in case they do.

Meanwhile, past performance would absolutely suggest that investors in bond funds should be prepared for periodic bobbles in their principal values. But that's OK, provided the investor's expected holding period is reasonable given the expected frequency, depth, and duration of those dips. Short-term bond funds (whether broadly diversified funds or government-focused options) aren't a cash substitute, and you should be prepared for drops in value that last for more than a year. The typical short-term bond fund has posted losses in 7% of rolling 12-month periods. In my model bucket portfolios, I use short-term bond funds as next-line reserves in case the cash cushion becomes depleted and a retiree has additional cash flow needs.

Meanwhile, the duration stress test will show that intermediate-term core bond funds are likely to experience bigger losses than short-term bond funds when interest rates go up. (That has been the case over the past six months.) And historically, intermediate-term funds have experienced a higher percentage of one-year rolling periods when their returns were in the red than short-term funds. Intermediate-term funds lost money in rolling one-year periods 19% of the time. That suggests that prospective investors hold them with an even longer time horizon in mind than short-term vehicles. Over rolling 36-month periods, intermediate-term core funds posted losses 6% of the time.

What if you're buying and holding individual bonds to maturity? If you're not selling and your bond is from a creditworthy issuer that makes good on its obligations, rising rates don't pose a direct risk of losses. Even so, as a buy-and-hold individual bond investor, you'll be missing out on the chance to swap into higher-yielding bonds when they become available, something that a bond fund can readily take advantage of. Smaller investors may also have a difficult time adequately diversifying with individual bonds.

Cash: Shop Around

Even as rising yields hurt bond prices, long-suffering savers in good old cash investments—certificates of deposit, money market funds, and so on—stand to benefit. After all, cash investors don't experience changes in their principal values, so rising yields are an unequivocal good for them.

Cash yields have indeed gotten better over the past six months, underscoring the merits of shopping around for the best rates. The yields on many money market funds have risen above 2%—still low, but far better than the ultralow yields they began this year with. Meanwhile, interest rates on online savings accounts, historically one of the higher-yielding cash account types, remain in the neighborhood of 2.0%-2.5%. You can usually obtain a higher payout on CDs: Two-year CD rates are over 3.5% in many cases. But the trade-off is that you need to keep your money in the CD for a predetermined period of time, during which time yields on other cash investments could rise.

The fact that yields remain pretty low, combined with high inflation, argues for not holding more cash than you need for emergencies or near-term spending needs. It also underscores the importance of not settling for the convenience of notoriously low-yielding cash options like brokerage sweep accounts.

Stocks: Diversification Matters

Stock performance can be a mixed bag in periods of rising yields, underscoring the value of diversification across the Morningstar Style Box.

On the one hand, strong economic conditions typically precipitate rising interest rates. Right now, for example, consumer spending is robust and unemployment is ultralow. Of course, inflation is in the mix, too; that and the higher borrowing costs that can accompany higher yields have the potential to reduce profitability. But if interest rates and/or inflation don't rise so dramatically that they derail that growth, rising yields aren't inherently bad for stocks. In fact, stocks' cumulative return during periods of rising interest rates has been positive.

In the short term, however, interest-rate hikes can have a negative effect on stocks. While growth stocks haven't been consistently worse performers than value stocks during periods of rising rates, they've been hit particularly hard during the recent spike in interest rates for a few different reasons. The key one is that growth stocks had substantially higher valuations at the outset of recent market volatility, leaving them vulnerable to whatever worry came along—in this case, higher rates. Investors often justify growth stocks' prices by looking at their distant cash flows, and higher interest rates mean that investors use a higher discount rate to value those cash flows. That reduces the valuations that are defensible for growth stocks. That's not to say that you should purge your portfolio of growth stocks, especially given the drubbing they've already taken so far this year. But it's also wise to make sure that you're not overdoing them.

Real estate equities have also been struggling for the year to date, with the Morningstar US Real Estate Index down about 24%. Like growth stocks, REITs had an exceptional year in 2021, so their valuations were arguably elevated coming into this period. Moreover, higher interest rates embellish bonds' attractiveness relative to higher-risk income-producing alternatives like REITs. REITs' weak recent returns are an argument against using them—or any equities, for that matter—in place of bonds if you have a short anticipated holding period.

The energy sector has been a rare bright spot in the stock market so far this year. Skyrocketing energy prices earlier this year enhanced the profitability of energy firms, with large energy firms like Exxon Mobil XOM and Chevron CVX delivering blowout earnings. Strong energy-sector performance and lower starting valuations for value stocks are key reasons why value-oriented stocks and funds, as well as those that buy higher-yielding stocks, have held their ground so far in 2022 while the broad market has fallen. Vanguard Value ETF VTV and Vanguard High Dividend Yield ETF VYM have each lost about 10% even as the S&P 500 dropped 20% for the year to date through Sept. 21. Thus, if you haven't checked your portfolio's style box exposure recently, make sure you've topped up exposure to the value side of the style box. Even with value's recently strong performance, a portfolio that was 50% U.S. growth and 50% U.S. value 10 years ago would be 55% growth and 45% value today.

A version of this article previously published on Feb. 17, 2022.