With interest rates on the rise and expected to rise further, now may be a good time to start thinking about tweaking your portfolio.
What has worked over the last few years of very low interest rates may not work as well as interest rates rise and the economy improves.
“Our expectation would be that rates would increase gradually,” says Albert Brenner, director of asset allocation strategy with the wealth management division of People’s United Bank in Connecticut.
He puts the odds at 50-50 that the Federal Reserve’s short-term policy rate hits 3 percent by the end of 2019.
There is the possibility that the central bank would raise rates faster if the economy got overheated, a scenario Brenner doesn’t think likely. On the other hand, the Fed could raise rates more slowly if economic growth isn’t as fast as expected, he says.
Andrew Altfest, managing director with Altfest Personal Wealth Management in New York, thinks interest rates will rise faster than people expect.
But there is a lot of uncertainty on the timing and magnitude of hikes depending on the pace of inflation and amount of fiscal stimulus, he says.
Rates are rising as inflation expectations pick up, and financial portfolios will require different allocations now than they have in the past, Altfest says.
[See: 9 Under-the-Radar Ways to Buy Financial Stocks.]
He sees new clients basing their allocations on what has been working, often having a huge concentration in large-capitalization U.S. equities.
Their other holdings might include a smattering of smaller companies, some international exposure and some longer-term bonds, he says. They also probably have a decent amount in cash because that’s how a lot of people deal with uncertainty.
While this type of portfolio has done well in recent years, it won’t do as well in a rising interest rate environment, Alfest says.
Invest with volatility in mind. Because there’s so much that isn’t known about the timing and amount of increases, investing with uncertainty in mind is key, he says. Official news on interest rates as well as people trying to read between the lines will create volatility in financial markets, he says.
Strategies to deal with this include hedged equities that use options to manage the downside in portfolios, he says, pointing to the JPMorgan Hedged Equity Fund (ticker: JHQAX) and the Swan Defined Risk Fund ( SDRAX).
Change your bond holdings. In the previous years of low interest rates, people didn’t have to worry about bond price declines, Brenner notes.
That is now changing, but investors shouldn’t exit bonds altogether because they still have a role to play with risk mitigation, Brenner says. “You can’t do without them,” he says.
But it is OK to pare these holdings back as interest rates rise.
In their place, you can add alternatives such as hedged equities, certain real estate strategies and event-driven plays such as merger-arbitrage investing, he says. The Third Avenue Real Estate Value Fund ( TVRVX) offers real estate exposure and the BlackRock Event Driven Equity Fund ( BALPX) is an event-driven strategy, he says.
Also, investors should buy securities that are going to have less risk in a higher interest rate environment, he says. Those include shorter-term bonds, Treasury inflation protected securities and certain securities tied to the housing market called non-agency mortgage-backed securities, he says.
Larry Rosenthal, president of Rosenthal Wealth Management Group in Manassas, Virginia, recommends that people pay attention to bond duration risk, meaning how much its price can decline as the fed funds rate increases.
[See: 10 Skills the Best Investors Have.]
With rising rates, investors should switch from longer-term to shorter-term bonds, he says.
Another option is to look for what are called bank loan funds, Rosenthal says. These tend to do better than more conservative funds as the economy expands, he says. But they can also contain riskier loans, so they should be paired with shorter term bonds as a hedge, he says. Bank loan funds carry credit risk and economic risk, so pull out of them if the economy starts to contract, Rosenthal says.
Even though shorter maturity bonds will face less pressure than longer-term bonds depending on how fast interest rates rise, Brenner doesn’t recommend going with all short-duration bonds.
That’s because you won’t earn much yield, he says. If you purchase a longer duration corporate bond fund that yields, say, 3.5 percent, you still may come out ahead even if that bond suffers some price loss, he says.
Although they are riskier investments, having a high-yield allocation in bonds gives some cushion as prices come under pressure, Brenner says.
Shift your equity holdings. Stocks tend to do better than bonds in higher interest rate environments, Altfest says. And non-U.S. equities are more reasonably priced compared with domestic stocks right now, Altfest says.
While there are opportunities for investing outside the U.S., Brenner notes that shares of foreign companies are often cheaper than those of U.S. companies because international markets are riskier.
However, international developed markets such as Europe and Japan are at an earlier stage of recovery, meaning their shares may have more room to rise than those in the U.S., Brenner says. That potential for greater growth combined with lower valuations can make those international markets attractive, he says.
When investing abroad, Brenner recommends hedging currency risk as the dollar could get stronger. One of the funds his company uses is a currency hedged exchange-traded fund, the WisdomTree Europe Hedged Equity Fund ( HEDJ).
Brenner recommends that U.S. investors have some home bias because they will be paying for their retirement or children’s college in U.S. dollars. So having only 25 to 30 percent of their money in international equities is prudent, he says.
Large-cap U.S. equities have been a good place to be and probably will remain so over the next year, Brenner says.
Rosenthal recommends purchasing large-cap companies such as Caterpillar ( CAT) or Dow Chemical Co. ( DOW) because those types of companies do well when the economy is expanding.
For the portion of your portfolio that is invested in U.S. equities, don’t forget to buy value stocks, Altfest says. So far this year, U.S. high-quality stocks have performed the best, so value stocks are cheaper right now, he says. “They’re a relative bargain.”
[See: 7 Tips for Finding the Best Target-Date Funds to Buy.]
Banks also tend to be a good place to invest in higher interest rate environments, and there are a number of large and regional banks in the value category, Altfest says, pointing to the John Hancock Regional Bank Fund ( FRBAX) and John Hancock Financial Industries Fund ( FIDAX) for exposure.
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Overhaul Your Portfolio As Interest Rates Rise originally appeared on usnews.com
