The Federal Reserve raised interest rates 25 basis points in December, marking the first time in nine years the central bank has hiked rates.
While this increase was well-telegraphed, the question remains about what the Fed has in store next. No one is calling for a return to much higher interest rates of years past, but given the change in the Fed’s stance, it’s worthwhile for investors to review their interest-rate-sensitive investments to see if they need to take steps to minimize potential impacts of a rising interest-rate environment.
Investors should change their mindsets. Bryce Doty, the Minneapolis-based portfolio manager of Sit Investment Associates, says investing in a rising interest-rate environment takes a different approach than what people have been used to for the past several years.
“It’s been so long since the Fed has raised rates that as seasoned of a group as we are here, we still have a few analysts that have never invested in a rising interest-rate environment. It’s hard for me to kind of imagine it. It takes a different mindset,” he says.
Generally, what it means is that investors can expect a flatter yield curve — that is, shorter-maturity yields rising faster than longer-term yields.
Rob Waldner, chief strategist and head of global macro at Invesco, based in Houston, says income investors should keep the specter of rate hikes in perspective. “Interest rates may be rising, but that does not mean that Treasuries are going back to 4 percent. It will be a long time before Treasuries offer a compelling investment opportunity from a yield perceptive,” he says.
Even if rates aren’t expected to rise very much, there’s still a lot of uncertainty about what will happen, says Steve Wruble, chief investment officer at RiskX Investments in New York.
“Nothing is guaranteed in what interest rates are going to do. I think that having a diversified mix of strategies of what’s going on in the market becomes key to a core portfolio, especially when it comes to income,” he says.
A portfolio review is in order. Because of the low interest-rate environment, many income investors searching for yield gravitated to higher-risk investments, such as master limited partnerships that mostly invested in energy infrastructure, high-yield bonds and real estate investment trusts. And many of those investments were hit hard as investors started to worry about the impact of rising interest rates.
Wruble says now is a good time for investors to reflect on what they want their portfolio to accomplish.
“The first step is to … look at what type of income expectations, downside [the investor is willing to accept] and their time horizons are all involved in the portfolio,” he says.
David Spika, global investment strategist at Dallas-based GuideStone Capital Management, says because the Fed is exiting the extraordinary circumstances that caused it to keep interest rates at zero for seven years, the normal playbook of how to invest in a rising-rate environment is different than usual.
“In a normal environment, you would want to reduce your bond holdings and allocate more to equities. In this environment, we suggest investors not make big changes in their portfolio,” he says.
Investors are better off if they hold high-quality, short-to-medium-duration fixed-income holdings, meaning those with a maturity of five years or less, he says.
“I wouldn’t recommend reducing exposure to high-quality, short-to-medium-duration bonds, because the global economic growth environment is likely to be slow, and interest rates, even after the Fed begins raising them, are going to remain very low, not only here but around the world for the foreseeable further,” Spika says.
Spika advocates seeking corporate investment-grade bonds, Treasury notes and agency bonds, which are bonds issued by agencies of the federal government.
But Waldner says the concerns about duration are overblown because of the likelihood that the rise in interest rates will be modest. That also means returns will be limited.
“The days where you were getting 20, 30 percent returns are not there. We think 2016 might not be too different from 2015,” he says.
Consider municipal bonds. One sector that usually does well in a rising-rate environment is municipal bonds, Walder says. “There are quite a few good opportunities in there. Munis are a great asset class. It’s directed at the U.S. domestic economy, [and investors] get tax benefits.”
Look for municipal bonds that are project-finance or revenue bonds, such as those that back projects such as toll roads or water desalination plants, versus general obligation bonds. Some of the troubles in the muni bond market, such as the Detroit bankruptcy and Puerto Rico, revolved around general obligation bonds, he says, which demonstrated the limits municipalities will use in their taxing power to pay off the bond holders, he says.
“So if you’re associated with a project, and it’s a good economic project — it’s a hospital or a toll road or a bridge or plant or a building — that’s a firmer foundation,” Waldner says.
Doty says the Fed can raise interest rates while still staying accommodative to the economy. Even slightly higher rates may encourage banks to start lending.
“If rates go up to 0.50 percent, hoarding cash is no longer a profitable venture for them. If they’re paying 50 basis points on their deposits, and they’re only earning 25 basis points on their reserves, that doesn’t make sense. … They’ll go back to be motivated to lend money, and I think it will be very stimulative in the marketplace,” he says.
That could cause an uptick in inflation, and that may make Treasury inflation protected securities viable, Wruble says. TIPS, as they are known, have not been viable in the low-inflation environment, but he points out that there has been an uptick in the consumer price index, and if that continues, a small allocation to TIPS might make sense.
Spika says overall, investors shouldn’t worry too much about interest rate hikes.
“Rising interest rates are not something to fear. The Fed would not be raising interest rates if they did not have confidence in the U.S. economy,” he says.
More from U.S. News
9 Ways to Pile Into High Yield With Preferred Stocks
8 Stocks Headed for a Fall in 2016
8 Stocks to Buy for a Great 2016
How to Fed-Proof Your Portfolio originally appeared on usnews.com
