Rising Rates and Your PortfolioChristopher Briggs, RRC®
Interest rates have been held at historically low levels for many years, helping to support economic growth and propping up the housing market, much to the chagrin of retirees who would like to depend on interest for income. But what is in store as rates continue their gradual rise?
Many investors understand the inverse relationship between interest rates and bond values. As interest rates rise, the capital value of existing bonds goes down. Here’s why: Consider an investment of $100 in a 10-year bond that pays a 2 percent coupon. If interest rates rise to 3 percent, you wouldn’t be able to sell the same bond at its $100 face value, because you could buy a new bond for $100 with a higher coupon rate. As such the bond’s market value will decrease to offset its lower interest rate, however, GIC (Guaranteed Investment Certificates) rates will go up.
When it concerns our clients’ investment portfolios, we manage this change in different ways.
In a rising rate environment, it is important to keep maturities of bonds relatively short to protect capital, and stagger GIC’s over different lengths of time. With respect to bonds and their maturities, the capital can be reinvested in new bonds that provide higher interest rates. A laddering approach, with maturities spaced over time, may also help to manage interest rate changes and offer predictability in generating future income streams. Various types of bonds (government, investment-grade, high-yield, etc.) may perform differently when interest rates are rising or falling so depending on the investor’s particular situation, diversifying across fixed income investments may help to provide protection.
A rising interest rate environment can also affect equity markets.
A popular belief is that rising rates put downward pressure on stocks. But this shouldn’t be cause for alarm. Interest rates typically rise during a strengthening economy, which easily can offset any softness over the longer term. Remember that fixed income plays an important role, helping to preserve capital and create diversification for your investment portfolio.
When we reach a crossroad, an educated decision is necessary.
As we continue our investment due diligence and uncover what different Investment Fund Managers are doing to protect clients on the downside of a challenging market, while continuing to provide upside potential, we come to a crossroad. Most have heard of using fixed income or bonds as a safety net when the equity/stock markets are turbulent, but what does one do when there’s questions around the fixed income space that could be facing some adversity? Just today we heard from two Investment Fund Managers that our firm widely uses, and both had different ideas where they feel the fixed income market is going to prevail, yet there is a third that has a different view also:
- On one side of the equation we are told that rates are going to rise which will negatively affect the longer-term less risky bond market; one should look to high yield bonds with short duration, no longer than 2 years.
- On the other side of the equation we are told that although rates will rise, it’s better to be longer term in the fixed income space, in the duration of 5 years in risk-free government duration bonds.
- Yet a third investment fund manager we use is currently in the duration of 7.6 years.
Each has supporting evidence that their case is accurate, and each are equally respected in the investment realm, therefore, which way should an investor go?
At Precision Wealth Management, we believe in all these investment fund managers that have provided this information because they have proven to be successful in the past. Past performance isn’t always indicative of future performance, and surely not all of them can be 100% right, so which direction would one want to put more emphasis on?
Although we don’t see our clients every day, we are working hard for them every day behind the scenes to be sure that our strategies we have in place are the right ones, and uncovering as much research as possible to make these educated decisions. At PWM, we are a Fee Based Asset Management firm, which means we are not tied into certain products and there is typically no financial implication to make quick changes as the market adjusts if we feel we need to.