Diversification is key to mitigate impact of rising rates.
Earlier this month, the Federal Reserve (Fed) announced they will start taking actions to raise interest rates and end their quantitative easing policy to halt rising inflation. With inflation currently around 7.00%, businesses and consumers are feeling the pinch of higher prices. The Fed’s actions are designed to reduce the inflation rate to a more comfortable 2.00%-3.00%. To accomplish this, the Fed will raise its Federal Funds rate. The Federal Funds rate is the rate at which banks can borrow and lend from each other so they can continue to provide loans to businesses and individuals. They will also end their policy of quantitative easing. Quantitative easing is a monetary policy that allows the Central Bank to purchase long-term securities from the open market. The policy increases the amount of money in the money supply, encourages lending and investment, and lowers interest rates. By raising interest rates and ending quantitative easing, the Fed hopes to reduce the amount of the money in the money supply and bring inflation rates down to more comfortable levels.
What could be the impact of rising interest rates on your investments? Bond prices typically move in the opposite direction of interest rates, meaning rising interest rates generally cause formerly issued bond prices to fall. This is commonly known as interest rate risk. When the yield on newly issued bonds is higher than the yield on older bonds, the newly issued bonds have more value. If you own an older bond, you must sell that bond at a discount to entice someone to buy it, otherwise they would just purchase a new bond. Thus, the value of old bonds decreases when interest rates increase. Additionally, with higher yields available with new bonds, many investors tend to sell their current bonds to purchase the higher-paying ones. Heavy selling causes the prices of old bonds to fall even more.
The best way to manage interest rate risk is with a diversified portfolio, including international and domestic bonds with short to intermediate maturities, as they may be less affected by rate hikes. The sooner a bond matures, the sooner you can use the proceeds to buy bonds that offer higher coupons. The trade-off is that bonds with shorter maturities tend to pay lower coupons than long-term bonds. A mix of short-term, intermediate-term, and high-yield bonds is worth considering. Each offers value in different ways, so not all your bond holdings will be as exposed to rising interest rates.
If you do not want the hassle of buying and selling your own bonds, bond mutual funds and exchange-traded funds (ETFs) are good options. The fund managers are consistently replacing maturing bonds with newly issued bonds to adapt their portfolio to changing rates. This can often reduce the negative impact of rising interest rates on the value of your bond holdings.
Although less predictable, stocks also tend to move in a negative direction when the Fed increases interest rates. The reason for this is that businesses, including large corporations, now must borrow money at a higher rate. This means more money must be allocated to paying back the loan(s), so profits tend to shrink. Additionally, consumers are also borrowing at higher rates. Thus they too must allocate more toward paying back their loans and have less discretionary income to spend. Less spending means less revenue and profits for businesses.
If companies are seen as cutting back on their growth due to less borrowing or are less profitable because of higher debt expenses or less revenue, their stock price will often drop. If many companies experience these declines, the whole market, or key indexes such as the S&P 500, the Dow Jones Industrial Average, Nasdaq, and the Russell 2000, will go down.
Just like with bonds, the best way to manage interest rate risk is by being diversified. The Fed raising interest rates is primarily a US-focused event. Although other countries could follow suit, it is unlikely to be matched globally. Therefore, owning a mix of US-based stocks, mutual funds, and ETFs, along with international and emerging market holdings, is the best way to reduce the impact that raising rates has on your stock positions.
What is the overall takeaway? Diversification is key. The more diversified your stock and bond holdings, the less affected you are likely to be by rising interest rates. To take that one step further, the more diversified you are, the less affected you are likely to be by any event that negatively affects one specific type of investment.
The material has been prepared or distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Investing involves risk, including risk of loss. Before investing, you should consider the investment objectives, risks, charges, and expenses associated investment products. Investment decisions should be based on an individual’s own goals, time horizon and tolerance for risk. Past performance is no guarantee of future results. Diversification and asset allocation do not ensure a profit or guarantee against loss. Consult your financial professional before making any investments.