As rates tick up, investors should resist overemphasizing cash, stress-test their bond funds, and be mindful of other rate-sensitive assets.
Jason Stipp: I'm Jason Stipp for Morningstar.
Market watchers are bracing themselves for the first interest rate increase in almost a decade. Joining me to discuss some portfolio-level dos and don'ts for a rising interest rate environment is Christine Benz, our director of personal finance.
Christine, thanks for being here.
Christine Benz: Jason, great to be here.
Stipp: Christine, you brought a short list of do's and don'ts for investors in a rising interest rate environment. The first thing you say is to keep the big picture in mind, because rising interest rates aren't entirely a bad thing for investors.
Benz: That's right. A lot of investors have been assuming that rising rates will be this unmitigated disaster for their portfolios. But certainly if they have cash in their portfolios, rising rates will be their friends, because you are able to pick up higher yields on those very safe instruments.
If you are someone who has CDs in your portfolio, one idea to potentially capitalize on rising rates is to consider laddering a CD portfolio--so, buying CDs of varying terms. That way you've got some maturing at various points in time, and you'll be able to take advantage of higher yields as they come online. It's also important to remember, though, you don't necessarily have to have a laddered CD portfolio. Even if you have an all-in-one portfolio, like a money market account, your fund manager will be able to take advantage of those higher yields as they come online as well.
Stipp: An important thing to avoid, though, is keeping too much money in cash or very short-term investments. This is something some investors might be inclined to do if they're worried that interest rates will rise. But you shouldn't overdo it.
Benz: I think that's the case, and the reason is that no one is expecting interest rates to really take off and ascend very rapidly from here. When you look at cash yields, even if yields go up a little bit, they'll probably still be in the red once you factor in inflation. There is a serious opportunity cost to having more in cash than you absolutely need.
I think the old rules of thumb still make sense for most people. If you're a working person, you want to have that emergency fund that accounts for three to six months' worth of living expenses. If you're a retired person, I'm a big proponent of what's called the "bucket approach" to retirement portfolio planning. That means you're holding one to two years' aside in true cash instruments. Any more than that, though, you really do run the risk of running into the red once inflation is factored in.
Stipp: Aside from my really short-term instruments, one thing I can do as an investor is a stress test on my fixed-income funds, and see what might rising rates do to those funds.
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Benz: That's a great idea. If you have bond funds in your portfolio, find the fund's duration, which is a statistic you could find on morningstar.com. Find also the SEC yield, which is a snapshot of its most recent yield. Subtract that SEC yield from duration. That's the rough amount that you would expect to see that product lose in a one-year period in which interest rates trended up by 1 percentage point. And I don't think anyone is calling for a 1-percentage-point increase in rates anytime soon, but take a look at that, run the numbers, do the math.
When you look at the typical intermediate-term bond fund today, you see a yield of roughly 2% on a high-quality bond portfolio, and a duration of maybe 5 years. That's a 3-percentage-point loss in that one-year period in which rates went up by 1%--not a big deal for most investors. I think that it helps put some of these rate worries in context.
If you do have a long-term government bond fund in your portfolio, you can see that it'll be much more vulnerable in a rising rate environment, but most people aren't owning long-term government bonds at this point in time.
Stipp: A lot of bond investors, however, aren't really accustomed to losses in their fixed-income portfolio, so if I stress test, and I see I might experience some losses, you say one thing I shouldn't do is jettison those bond funds.
Benz: That's right, because over time, you will tend to get paid for taking a little bit more duration risk than you will be paid by holding cash. I don't think it makes sense to get carried away with rate worries. Certainly, most of the high-quality core bond funds aren't taking a lot of duration risk. Most investors probably don't have a reason to throw those funds overboard.
Stipp: Another thing that investors should do outside of their fixed-income portfolios is think about other parts of their portfolios that might be sensitive to rising interest rates.
Benz: That's right. Don't just stop with your bond portfolio, also take a look at other portions of your portfolio. Utilities would be one area that investors look to sometimes as a bond substitute or a bond alternative because of their generally pretty high income streams. In a rising rate environment, bonds might tend to look more attractive relative to utilities.
REITs would probably fall into the same category. It's a category that we tend to see be responsive in rising rate environments. When we had that "taper tantrum" a couple of years ago, we saw some of these categories sell off pretty sharply.
Emerging-markets bonds are another category that some market watchers believe could be vulnerable in a rising rate environment here in the U.S. One thing I would say, though, is that we've seen some of these categories already begin to anticipate the Fed's rate increases. We've seen some pretty awful performance in emerging-markets bonds already. Arguably, some of the rate worries are already embedded into emerging-markets bond prices. But nonetheless, take stock of what you've got, don't assume that the rate effects will occur strictly in your fixed-income portfolio.
Stipp: And a final thing you say that investors should do is fasten their seatbelts, because although a rate increase has been highly anticipated, we still could see some volatility after we get details of the Fed's plan.
Benz: That's right. Even though a lot of these effects are priced into the bond and perhaps even the equity market today, I wouldn't be entirely surprised to see a few shudders run through the bond market, especially if trading volume is down a little bit during this period. Investors shouldn't panic.
I think it's worth remembering that interest rates, in terms of equity prices, tend not to be highly correlated. A rising rate environment doesn't necessarily portend bad things for equity investors. It's important to remember that, when you think about the big drivers of equity market returns, it's valuation. And right now, actually, we've seen some volatility in the equity market. Prices have come down a little bit. They're by no means cheap, but valuations over time will tend to be the factor most closely correlated with equity market returns--not the direction of interest rates.
Stipp: Christine, always great to hear about how to keep perspective on the market from you. Thanks for joining me today.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.
