Interest rates have been on the rise since hitting a historic low in mid-2016. Is this a good thing?
To borrow a phrase most often associated with politics, where you stand on that question depends on where you sit. If you’re looking to buy a home, or have a small-business loan with a variable rate, you might be getting a little antsy. But if you keep most of your money in cash, you might be feeling a little tingle up your leg as you watch the interest rate thermometer inch up.
But what about serious investors? What do rising rates mean for them, and how should they tweak their portfolios to make the most of this changing climate? Again, it depends. Various assets are impacted in different ways by an ongoing increase in interest rates. We’ll examine how several types of investments typically fare in such an environment. But first, let’s check our bearings so we know where we are in the investment and interest rate cycles. Can’t get where you want to go unless you know where you are, right?
The economy is in pretty good shape as measured by my CHIME index. Consumer spending, Housing, Interest rates, Manufacturing and Employment are turning in solid, if not spectacular, numbers.
Since the early 1900s, stocks have moved in a series of long bull and bear cycles. The bull cycles run about 17 years, during which the market returns an average 14 percent annually. We are currently eight years into one of these bull cycles, according to the analysts. Bonds run in longer cycles of about 30 years. We appear to be nearing the end of a bull cycle for bonds.
Bond prices have been under pressure lately because interest rates are rising after drifting downward for 35 years, with the Federal Reserve predicting that rates will continue to rise over the long term with the Federal Funds Rate moving from its current 0.63 percent to 2.88 percent.
The pace of the interest rate growth is also a factor. If rates spike, like a nasty fever, several asset categories might suffer. Gradual, moderate growth that indicates a healthy economy is preferable, as rates will rise more methodically.
Here’s how several common asset classes could be impacted by this new environment. I refer to this lineup as B-CRISP — Bonds, Closed-End Funds, REITS, Income Commodities, Stocks and Preferred Stocks.
Bonds: Bonds move inversely with interest rates. During those 35 years of declining rates, bonds were thriving. But rising rates create a headwind for bond prices. This doesn't mean investors should abandon bonds. Quality bonds can provide a portfolio with low-risk protection against the cyclical nature of stocks and a steady stream of interest income.
Closed-End Funds: CEFs have been feasting on the recent record-low interest rates, which have allowed the funds to boost their return while investing in high-return assets. Increasing interest rates mean higher capital costs for CEFs, which could reduce distributions.
REITs: Real Estate Investment Trusts offer investors a way to own real estate by purchasing shares in a portfolio of residential or commercial properties. For the past 20 years, REITs have historically returned 10.9 percent annually. It's natural to think that REITs would be hurt by rising rates, and their impact on real estate borrowing. But the reality is a bit more nuanced. While REITs do suffer when rates spike, rising rates are a good thing in the long term as they indicate a strong economy and the associated demand for residential and commercial properties.
Income Commodities: Rising interest rates often signal a growing economy — one that will use more commodities. The inflation that comes with that growth can also drive commodity prices higher. MLPs, which allow investors to share in the profits from energy storage and transport systems, can also benefit from the higher demand created by a growing economy.
Stocks: Rising interest rates are a good thing for stocks — up to a point. Stocks tend to gain up until the 10-year Treasury interest rate hits about 4 percent to 5 percent. At that point, interest rates start to become a drag on the economy and, as a result, corporate earnings. Thus, stocks start to suffer. The 10-year Treasury is currently around 2.4 percent. Corporate earnings are strong and are expected to remain so for the rest of 2017.
Preferred Stocks: Preferred stocks are a cross between a stock and a bond. They are issued at a par value and pay income in the form of dividends that may either be fixed or float. As a result, like bonds, preferred share prices are inversely tied to interest rates. As rates go up, preferred stock prices come down. A preferred stock with a fixed coupon rate that was set when interest rates were low might lose its appeal as rates rise.
So, what’s an investor to do in a rising rate environment? If you have a well-crafted long-term investment strategy, you need to stick with that overall plan. Now, as always, you do need to keep tabs on your portfolio and make tweaks as necessary to reflect changes in either your personal situation or the financial landscape.
Give your portfolio the once-over and make sure you are positioned to make the most of the current rate environment.
Wes Moss has been the host of “Money Matters” on News 95.5 and AM 750 WSB in Atlanta for more than seven years now, and he does a live show from 9-11 a.m. Sundays. He is the chief investment strategist for Atlanta-based Capital Investment Advisors. For more information, go to wesmoss.com.
DISCLOSURE
This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.
