Rising Interest Rate Environment
What to do about your Bond Portfolio in a rising interest rate environment ? Everybody has this breakdown in some capacity regardless of how much money you have, how old you are? We all have risk money and we have safe money. The risk money is always in the form of stocks, equity, mutual funds, real estates, and commodities and on the safe side we have CDs, annuities and bonds. But the problem in a rising and trade environment we know this is axiomatic if interest rates go up, bond values go down.
When you look at the risk and a safe money side where you are getting a 3 to 5% return with no downside, means you cant lose anything on the downside, would you like that kind of investment for your safe money? Most people say Yes but if this question asked in a different way.
A lot of investors have been assuming that rising rates will be this unmitigated disaster for their portfolios but certainly if you have cash in your portfolios, rising rates will be their friends because then you are able to pick up higher yields on those very safe instruments. If you are someone who has CDs in your portfolios, one idea to potentially capitalize on rising rates is to consider laterally, so buying CDs of varying terms so that way you got some maturing at various points in time and you will be able to take advantage of higher yields as they come online. It is also important to remember though you don’t necessarily have to have a lateral 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.
Important thing to avoid keeping too much money in cash or very short term investments, is something, some investors might be inclined to do if they worry that the interest rates would rise but you shouldn’t overdo it. The reason for this is that no one is expecting interest rates to really take off and ascend very rapidly from here so when you look at the cash yields even if yields go up a little bit they will probably still be in the red once you factor in inflation so there is a serious opportunity cost to having more in cash than you absolutely need, hence, the old rules of thumb still makes sense for most people. If you are a working person, you want to have that emergency fund that accounts for three to six months worth of living expenses. If you are a retired person, you should be a big proponent of what’s called the bucket approach to retirement portfolio planning, means, you are 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.
If you have bond funds in your portfolio, find the funds duration which is a statistic, find also the SEC yield which is a snapshot of its most recent yield, and subtract that SEC yield from duration. That’s the rough amount that you would expect to see the product lose in a one year period in which interest rates trended up by 1% point. When you see the intermediate term bond fund today, you see a yield of roughly 2% on a high-quality bond portfolio and duration of maybe five years so that is a 3 percentage point loss in that one year period and in which rates went up by one percent that is not a big deal for most investors. This will helps put some of these rates in context. if you do have long term bonds in your portfolio, or if you have a long term government bond fund in your portfolio, you will see that will be much more vulnerable in a rising rate environment.
Overtime you will tend to get paid for taking a little bit more duration risk than you will be paid by holding cash hence, there is no 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 the funds overboard. Another thing the investors should do outside of their fixed income portfolios is to look at your other portions of your portfolio, utilities would be one area that investors look to, sometimes this kind of 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. Emerging markets bonds are another category where some market watchers believe they could be vulnerable in a rising rate environment here in the US. Arguably, some of the rates worries are already embedded into emerging market bond prices but nonetheless take stock of what you have got. Don’t assume that the rate effects will occur strictly in your fixed income portfolio. Even though a lot of these effects are priced into a bond and perhaps even the equity market today, see a few shutters run through the bond market especially may be if trading volume is down a little bit during this period so investors shouldn’t panic. It is worth remembering that interest rates in terms of equity prices tend not to be highly correlated so a rising rate environment doesn’t necessarily portend bad things for equity investors. It is important to remember that when you think of big drivers of equity market returns its valuation and right now actually we have seen some volatility in the equity market prices have come down a little bit. They are by no means cheap but valuation over time will tend to be the factor most closely correlated with the equity market returns not the direction of interest rates.