Navigating a Rising Rate Environment

How a shift in Fed policy may affect your investments

By Paul Taghibagi, CFP, AIF | Special to the Palisadian-Post

During the seven-year period between December 2001 and December 2008, the Federal Open Market Committee (FOMC) altered the target Fed Funds rate on 28 different occasions.

Since lowering it to a range of 0 – 0.25 percent on Dec. 16, 2008, however, not a single attempt to raise rates ensued for the next seven years, as the Fed carefully assessed the fragile economic recovery.

Finally, this past December the long anticipated process of raising interest rates began with a small one-quarter percent increase.

Many see the recent move as the first of a gradual but steady effort to ratchet rates higher as part of a longer-term monetary tightening policy. But what exactly will that mean for your investment portfolio in general, and your fixed income holdings in particular?

A HISTORICAL PERSPECTIVE 

While conventional wisdom assumes that rising rates are generally bad for investors, past performance indicates otherwise.

Historically, despite short-term periods (months or quarters) where bonds struggle during rising rate environments, over a full market cycle of rising rates, both equities and fixed income have experienced consistently positive returns. The most recent (and perhaps most analogous) example is the extended 38-month rising rate environment that occurred between June 2004 and August 2007.

During this period, the Fed undertook a long, gradual tightening of the loose monetary policy it had enacted in response to 2001’s dot-com related recession. From a starting Fed Funds interest rate of just 1.0 percent, the Fed implemented 17 successive quarter-point rate hikes, eventually reaching a peak of 5.25 percent.

How did fixed income and equity asset classes hold up during that period? Remarkably well, as the following table illustrates:

Asset Class Returns 

(June 2004 – August 2007)

Short-Term Government Bonds: +3.5%

Long-Term Government Bonds: +5.99%

High Yield Corporate Bonds: +7.76%

Corporate Bonds: +4.44%

Equities: +10.45%

Source: Morningstar, Inc.

Similar results hold true over the four prior rising rate periods. Clearly, rising rates do not necessitate negative returns.

PACE OF CHANGE IS WHAT MATTERS

More so than the direction of change, it’s the pace of interest rate movement that investors should pay closer attention to.

While a sharp increase in rates over a short period of time will likely lead to negative returns, incremental increases over a longer period of time will have far less market impact. And based on everything we’ve seen and heard from the Fed recently, it appears the latter cautious approach is their intended course of action.

Keep in mind that when rates are rising, it’s typically a sign that the economy is doing better. Corporate profits are on the uptick and that translates to higher stock prices, so equities generally perform well.

But even on the bond side, there are a number of active portfolio management strategies that can help mitigate the negative impact if rates start rising quickly.

What makes sense? Consider keeping your bond maturities shorter. Look for higher coupon bonds with shorter durations rather than longer maturity government bonds.

Talk to your advisor about possibly increasing your allocation to high-yield corporate bonds and/or floating-rate bonds where interest rates adjust (often monthly or quarterly) so the impact of rate increases is lessened.

Take a closer look at global bonds, especially in this current rate environment, since many foreign countries are well behind us on the interest rate cycle—still lowering rates as we begin to increase them.

Finally, you may want to explore some long-short bond strategies. There are a number of funds designed specifically to do well in a rising rate environment.

Above all, however, strive to be an attentive rather than a reflexive investor as interest rates move higher. By being proactive and making adjustments along the way, you can use the environment to your advantage.

Paul Taghibagi may be reached at 310-712-2323, pt@seia.com or seia.com/paul-taghibagi/.