Armchair and professional pundits alike have been predicting rising interest rates for the past few years. Thus far, those predictions haven’t panned out. Since the global financial crisis of 2007 and 2008, the Federal Reserve has kept a lid on rates with the aim of stimulating economic growth. However, data shows an improving economy, and the Fed recently signaled it may be ready to start increasing short-term rates.
After wrapping up a two-day policy meeting in mid-December, Fed officials issued a statement suggesting it’s nearly time “to normalize the stance of monetary policy.”
For bond investors, rising rates would affect their holdings. As rates rise, bond prices decline. That’s because new bonds are issued at the higher rate, meaning existing holdings, bought when rates were lower, are not worth as much. The higher rates drive prices down. However, that doesn’t mean investors should panic and bail out of bonds entirely. Professional money managers recommend a few simple strategies to handle a rising-rate environment.
1. Don’t try to forecast where interest rates will go. Dan Goldie, president of Dan Goldie Financial Services in Palo Alto, California, and co-author of the book, “The Investment Answer,” suggests individual investors avoid interest-rate predictions altogether and instead focus on bond maturities and credit quality. In client portfolios, he uses a strategy that does not rely on interest rate forecasts.
“I don’t think that can be done accurately enough to add any value. In my portfolios, I keep the maturities short and the credit quality high,” he says. “If one does that, there’s no reason to be concerned at all about what rates do, because those securities have relatively low interest-rate sensitivity.”
2. Understand the role of bonds in your portfolio. Bonds serve as an anchor to stabilize the more volatile equity side of a portfolio, says Mary Talbutt, vice president and head of fixed income at Bryn Mawr Trust, headquartered in Bryn Mawr, Pennsylvania.
That anchor allows investors to ride out volatility in equity markets, even in extreme cases, such as the financial crisis of a few years ago. Bond investors were able to capture gains on the fixed-income side, rather than be completely exposed to the stock market meltdown.
“There should always be a certain portion of your portfolio that is more stable than just the equity markets, or just the preferred [stock] markets or real estate investment trusts. You should have diversification and not miss the opportunities in the equity markets, but you should always have an anchor for your portfolio, and fixed income is that anchor,” Talbutt says.
Goldie adds that investors should have an understanding of what they want to accomplish with their bond holdings. “The fixed income portion of a balanced portfolio is there to dampen volatility, not try for high returns. That would be the function of the equity portion,” he says.
3. Keep interest rates and global market conditions in historical perspective. Although interest rates were low at the end of 2014, they were not at historical lows.
“A rate increase has been anticipated for the last two years, and the reality is that rates have been lower,” says Andrew Horowitz, president of Horowitz & Company, a financial planning and investment management firm in Fort Lauderdale, Florida.
Horowitz says investors should be aware of how various asset classes have performed relative to others. For example, he points out that in 2014, long-term Treasuries posted a far better return than the Standard & Poor’s 500 index.
Horowitz suggests investors consider paring their holdings of U.S. Treasuries this year. “Keep a watch on the changes in the slope of the yield curve to better understand where the biggest changes are being seen,” he says.
Jack McIntyre, global fixed income portfolio manager at Brandywine Global Investment Management in Philadelphia, says investors who remember higher yields from the 1960s, 70s and 80s view today’s yields as disappointing. “They look at these and get sticker shock. Their perspective is that today’s yields are low relative to where they were 30 or 40 years ago, but if you go back 100 years, rates now are not historically low,” McIntyre says.
4. Expand your horizons beyond the U.S. According to a February 2014 Vanguard Group report, non-U.S. bonds are the world’s largest asset class. However, U.S. investors often have little or no exposure to foreign fixed income.
Rather than trying to bet on interest rates, McIntyre says investors should take a wider view of opportunities throughout the world. He suggests allocating between 15 percent and 20 percent of a fixed-income portfolio to international bonds.
“Think of it in the context of a more diversified bond portfolio,” he says. “Ask yourself, ‘Do I need to move a little bit of money outside the U.S., where there are better opportunities and a little better value?’”
To get even more specific, McIntyre says investors should look beyond developed markets this year and consider investments in emerging markets. “It may not be the story in the first quarter of 2015, but at some point, global capital is going to start breaking away from Treasuries and looking at these high-yielding markets,” McIntyre says.
“We’re in an environment in the fixed-income world where there’s no free lunch. You have to be willing to take on more volatility in moving some capital into those markets, but I think that will be the theme for 2015,” he adds.
Horowitz notes that investors in overseas investments must be cognizant of currency risk and should consider hedging that risk against a further rise in the dollar. Investors can easily accomplish that hedging with mutual funds. “Look for low-cost ETFs for U.S. exposure and mutual funds that currency hedge for outside-the-U.S. holdings,” Horowitz says.