It now seems as though interest rates may soon head higher, if not because there is hardly a chance rates can go lower, but because the economy may have reached an inflection point. Economic data is stronger than at any point in the last few years.
Home prices are rising quickly. Home sales are improving, and construction is picking up. Consumers are the most confident about the future than at any point since the 2008 financial crisis. Low rates have enabled consumers to pay down debts, or refinance at lower, long-run rates, making room for more consumption in their monthly budgets.
Explaining the Fed's Actions
The Fed has indicated its own preference toward higher rates. The Fed said that it could slow or even stop its $85 billion monthly purchases of long-dated mortgage-backed securities and US Treasury bonds. It would not, however, alter its short-term financing rate of 0-.25% until unemployment falls below 6.5% (unemployment currently sits at 7.5%).
Investors who haven't paid attention to the Fed's recent activity may not fully appreciate what the Fed has suggested. Historically, the Fed sought to target only the short-end of the yield curve by targeting different overnight lending rates. Post-financial crisis, the Fed started buying and selling long-dated securities to influence long-term rates.
The Fed's participation in markets for mortgage-backed securities and U.S. Treasury bonds should not be ignored. It has absolutely depressed rates on the long-end of the yield curve, which makes it cheaper for businesses, individuals, and governments to borrow for periods of up to 30 years. Should the Fed “taper” its purchases on the long-end of the curve, rates would naturally rise for long-term borrowing. In all reality, long-term rates have much more influence on borrowing and investment than the short-term overnight interest rate. To sum it all up, slowing long-dated bond purchases from the Fed would bring higher rates from the long-end of the curve all the way to the shorter-end. The Fed is displacing $85 billion of investment capital that would otherwise have to come from individuals, institutions, and governments to buy mortgage-backed securities and Treasuries. Simple supply and demand. Less demand means higher interest rates.
Safe-Haven Fixed-Income Investments
Bonds trade inversely to interest rates. When interest rates rise, bond prices go down. The longer the bond duration and the higher the interest rate, the greater the effect on bond prices.
If you currently hold bonds with 10-30 years to maturity, you'll see the largest capital losses when existing bonds are repriced to reflect rising rates.
There are only two methods for slashing your interest rate exposure:
- Shorten Maturities – Moving capital from 20-30 year bonds to maturities of 5-10 years would significantly reduce your exposure to higher interest rates. A very simple way to do this is to use a short-term bond ETF like the Vanguard Short-Term Bond ETF (BSV), which holds short-term government and investment-grade corporate bonds with a time to maturity of 1-5 years. The average is a little under 3 years. Of course, such a move would also cost you in the form of annual distributions from interest, since short-term bonds have a much lower yield than long-term debt. The benefit, of course, is that higher interest rates on long-dated bonds would have only a very small impact on capital gains or losses.
- Remove Interest Rate Policy From The Equation – A very small amount of debt securities available to the public offer floating interest rate payments. That means that the debt is written based on an index, whereby investors are guaranteed a certain return over an accepted interest rate index. (LIBOR is a common index for floating-rate securities). Floating-rate debt has only minimal exposure to interest rate risk, since higher rates would be reflected in the interest rate index, meaning that investors receive higher interest payments when rates rise and lower rates when rates fall. One choice here is the SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN), which is built on a portfolio that uses the 3-month LIBOR as a reference rate. Short-term investment-grade floating rate securities are relatively low yielding, however, and investors will earn just over 1% per year holding this ETF if interest rates stay where they are today. The alternative is the PowerShares Senior Loan Portfolio (BKLN) which invests in riskier bank loans issued by junk-rated issuers. However, the ETF rewards investors for accepting higher risk, with yields just under 5% per year. This ETF is also built on floating-rate securities.
Stock Moves to Make with Rising Interest Rates
So there are two simple options for bonds: go shorter-term or floating-rate. But what about equities? Shouldn't there be some correlation between higher rates and lower equity prices?
Absolutely. One of the sectors investors should consider cutting first is the utility business. I previously wrote about how utilities effectively trade like bonds because their cash flows are generally easy to forecast and the business is extraordinarily capital-intensive. With the whole sector rallying heavily this year, slashing exposure to utilities in favor of capital light industries looks like a smart move to make.
Forgoing utilities doesn't have to cripple yields. I'm a fan of a newly-launched ETF listed as WisdomTree U.S. Dividend Growth Fund (DGRW), which holds 300 dividend-paying companies with absolutely zero exposure to utilities. In fact, it's the only dividend fund on the market that completely ignores utilities from the mix.
Another area of concern are REITs and Agency Mortgages. These types of investments use short term lending to finance longer-term purchases. As rates rise, not only will borrowing costs for these companies rise, but there will also be pricing pressure on the assets that they are buying. As a result, they could experience short term losses. These assets typically don't fare well in periods of interest rate changes – it is difficult to hedge rate changes quickly. These investments typically perform best in a stable rate environment.
What other moves do you think are important in the face of rising interest rates?