With the Federal Reserve expected to raise interest rates this week, you need to familiarize yourself with how the move may affect your investment portfolio. Fortunately, there are steps you can take to minimize the damage. Historically, rising interest rates have been bad news for bond holdings. Start by reviewing your current holdings.
After decades of historically low levels, interest rates are finally beginning to rise, a development that could torpedo the investment portfolios and finances of the unprepared.
But if you know what steps to take, you can contain the damage and keep your portfolio and your overall financial situation from taking on too much water.
As the economy continues to strengthen, the Fed policy of sustained low interest rates, designed to boost economic activity after the great recession of 2008, is likely coming to an end. Although the Fed has raised rates only twice in the last 10 years, the pace of rising rates is expected to pick up in 2017, with the Fed indicating upward of three rate hikes this year.
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Here are some points to consider when seeking to protect your portfolio:
BAD NEWS BONDS
Rising rates are generally bad news for your existing bond holdings. When interest rates rise, new bonds pay higher rates. Investors holding existing bonds, which are now paying less, are usually unable to sell them for their full value because higher paying alternatives are now available.
You should review your current bond holdings to determine the potential damage as rates rise. A simple but effective way to estimate your risk is to look at your bonds’ duration — the approximate volatility (up and down price movement) of a bond or bond portfolio in relation to changes in interest rates. For example, a bond with a duration of 10 means that a 1 percentage point change, up or down, would raise or lower the value of the bond by about 10 percent. You read that right: If you own a bond fund or bond exchange traded fund (ETF) with underlying holdings that are 10, 15, 20 years or more in duration, you could lose 10, 15, or even 20 percent in value for every 1 percentage point rise in rates. If you own bonds with durations longer than two or three years, it might be prudent to exchange them for bonds with shorter duration If you own an indidual bond and don’t plan on selling it anytime soon, you might consider holding it to maturity, but prepare yourself for a rough ride until then.
Loading up on bonds as you approach retirement may not be a wise move. The traditional portfolio-allocation thinking has been that as you age, you need more stability in your portfolio to avoid potentially large losses from a steep stock market decline just before or during retirement. A long-cited rule of thumb holds that people should have a percentage of stocks in their portfolios equal to 100 minus their age, with the balance in bonds or other relatively safe assets. For example, a 60-year-old would have 60 percent of their assets in bonds and 40 percent in stocks. This formulaic approached may have worked well decades ago, but now that the nearly 30-year bull market in bonds may be coming to a halt, it may not work for many investors.
If you’re approaching retirement, consider reducing risk by seeking alternatives to bonds. These include floating-rate funds; Treasury Inflation-Protected Securities (TIPS), which have an interest rate pegged to inflation; or an array of short-term certificates of deposit with maturities structured to overlap (known as a ladder).
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BUYING A HOME?
If you’re planning to finance a new or vacation home, now may be the time. Consider accelerating your purchase decision to avoid higher interest costs. That may be inconvenient if you haven’t decided on what to buy, but buying right after a series of rate increases can bring regrets that can be calculated in real dollars — in the case of real estate, significant amounts over time.
ATTACK YOUR STUDENT LOANS
If you’re still paying off student loans, particularly if they’re adjustable rate loans, now may be a good time to review your payment options. Unfortunately, many health professionals are still paying down debt, given the protracted nature of their professional educations. Rising rates mean you should probably try to get these loans paid off sooner rather than later. It’s a good peace-of-mind builder regardless of what rates do. If you have adjustable rate loans, consider refinancing now to lock in today’s low rates.
WHAT ABOUT STOCKS?
Rising interest rates can also affect your stock holdings. The initial phase of rising rates can be good for the stock market, as this generally indicate an improving economy, but rising rates are not good for stocks long-term — particularly when increases are sudden or in rapid succession. But if you know what you’re doing or get the right advice, you can take advantage of interest rate changes by rotating your holdings into sectors that tend to do well in a rising rate environment. These sectors include energy, financials, consumer discretionary, technology, industrials and materials. As the market begins to cool, after higher rates begin to take their toll, you may want to shift into more defensive sectors such as utilities, telecom, consumer staples, real estate investment trusts (REITs) and healthcare.
By monitoring interest rate trends, you can be prepared to adjust your portfolio that can help keep rising rates from reducing the size of your nest egg.
Eric C. Jansen, ChFC®, is the founder, president and chief investment officer of Westborough, Mass.-based AspenCross Wealth Management (AWM), which provides fee-only retirement-income planning and investment-management services for high net worth clients nationwide.
The information presented is not intended as financial advice, and you are encouraged to seek such advice from your financial advisor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Keep in mind investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money. Diversification/Asset Allocation does not ensure a profit or guarantee against loss. Registered Representative/Securities and Investment Advisory Services offered through Signator Investors, Inc. Member FINRA, SIPC, a Registered Investment Advisor. AWM is independent of Signator. One Technology Drive, Westborough, MA 01581.