Retiree Do's and Don'ts in a Rising-Rate Environment
Rising rates aren't an unmitigated evil for your finances and portfolio, but some perspective is in order.
The Federal Reserve raised interest rates Wednesday and indicated that it's likely to increase rates twice more by year end. That brings the benchmark Fed funds rate up to 2%, its highest level since 2008. In a statement, the Fed noted that the economy was growing at a "solid rate," prompting the action--and expected further hikes--to bring interest rates back up to more normal levels.
The latest rate increase was widely anticipated in the market; long-term Treasuries, typically considered the most interest-rate sensitive of bond types, were flat last week.
That said, many market participants, especially retirees with fixed-income-heavy investment mixes, are reasonably concerned about what a period of rising interest rates could mean for their portfolios and for the rest of their financial lives. Will the bond market, which has experienced declining yields but enormous price appreciation over the past three decades, reverse course? Will the losses that bond investors have experienced over the past year persist, making bonds a lost cause (or worse) in the decade(s) ahead?
I think a more nuanced take is in order. Yes, higher yields have the potential to depress bond prices in the near term. Over time, however, they're apt to have a benefit for retirees, because income contributes the largest share of the return that bond investors earn. We've already started to higher yields accruing to investors in search of income: Even as many bond-fund types have experienced losses so far in 2018, the yield on the Barclays Aggregate is now above 3%, and cash yields have also been climbing steadily.
In addition, I think it's a mistake to assume that interest rates will run inexorably upward, much as they did in the 1970s amid runaway inflation. While the economy appears to be on solid footing and inflation is trending higher, inflation is nowhere near levels that could be described as "runaway." Moreover, the current economic expansion is now nine years old, one of the longest in U.S. history. Even as higher rates are a worry, it's also possible that economic growth could begin to wane. Such a scenario would tend to weigh on stocks, while rate-sensitive bonds could prosper.
As you consider your financial and portfolio strategies amid expected future interest-rate hikes, here are some dos and don'ts to help your portfolio and the rest of your finances, weather the storms.
Do Shop Around for the Highest Cash Yields
Not so long ago, 2.35% was the approximate yield on the Barclays Aggregate Index, while cash yields were barely in the black. Today, it's possible to pick up a 2.35% yield on a 14-month CD! Meanwhile, yields on money market mutual funds are closing in on 2%, and it's easy to find an online savings account that’s yielding 1.75%. That means it's time to re-shop your cash holdings to ensure that you're getting the best yield you can. As you do so, be sure to factor in your need for liquidity and FDIC protections. Yields will tend to be highest on CDs, and CDs offer FDIC protection (up to the limits); the downside is that you won't have daily access to your funds, so CDs are a poor choice for ongoing expenses. Money market mutual fund yields are now higher, in many cases, than those on online savings accounts; these funds offer daily liquidity but aren’t FDIC-insured. Online savings accounts are FDIC-insured up to the limits and offer daily liquidity; in many ways, they offer the best of both worlds.
Don't Let More Money Languish on Your Brokerage Sweep Account Than You Really Need
As you're attempting to wring a higher yield out of your cash holdings, don't ignore the cash you have sitting alongside your long-term portfolio holdings in your brokerage account. Such cash accounts, often called "sweep" accounts, offer ready access to purchase long-term securities, but they typically offer yields that are well below competing types of cash accounts. In most cases, brokerage sweep accounts are paying less--typically well less--than 0.50% today. You can usually find higher yielding money market mutual funds or savings accounts at your brokerage firm or mutual fund company. The key drawbacks relative to the sweep account is that money market mutual funds aren't FDIC-insured, and you won't have immediate access to your funds to purchase long-term securities; you'll need to place a sell order first.
Do Stress-Test the Impact of Rising Rates
Rising interest rates have a depressive effect on bond prices; when higher-yielding new bonds come available, that puts downward pressure on older bonds with lower yields attached to them. Rather than assuming Armageddon is nigh for your bond because of higher rates, it's useful to conduct a quick and dirty "stress test." For high-quality bond holdings, you could expect them to lose the amount of their durations, less their yields, in a one-year period in which interest rates trended up by one percentage point. Take Vanguard Total Bond Market, for example. With a duration of six years and a 3% SEC yield, investors could expect a roughly 3% loss if rates increased by 1 percentage point over the next year. (Indeed, it has already lost about 2% year to date owing to recent rate hikes and the expectation of more to come.)
Don't Assume Individual Bonds Are a Panacea
Rising rates are only a problem for investors in bond funds, right? Well, sort of. If you hold an individual bond to maturity and the issuer makes good on its interest payments, you won't lose money, even if interest rates shoot up over your holding period. But investing in individual bonds carries drawbacks of its own. It can be difficult for smaller investors to adequately diversify across bond sectors and issuers with individual bonds. Those individual bonds may be tough to research; as a small investor, high trading costs could eat into your returns. Bond mutual funds, by contrast, offer professional management and diversification. Moreover, an investor in individual bonds effectively locks in his or her yield, whereas the bond-fund managers can take advantage of higher-yielding bonds as they become available. This article discusses in greater detail the pros and cons of buying individual bonds, and this one discusses laddering bonds as a strategy for individual bond investors.
Do Rethink Your Debt
More and more people are carrying debt into retirement--mortgages and even student loans. And while rising interest rates may be a boon to savers, they're bad news for borrowers. The average rates on 30-year mortgages recently stood at 4.5%, their highest level since 2014. For new borrowers, those higher rates make it hard to beat debt paydown as the highest guaranteed return on investment that retirees can earn today. Moreover, changes in the tax code mean that many more taxpayers will get a bigger bang for their buck by taking the standard deduction versus itemizing; if they're not going to be able to take advantage of the mortgage interest deduction, that further embellishes the value of retiring mortgage debt sooner rather than later. Even investors who have older mortgages with very low rates of less than 3.5% may want to balance prepaying their mortgages with investing in the market. While safe yields have gone higher, you still can't find a 3.5% guaranteed return anywhere, and that interest may not be deductible on your return.
Don't Ignore Inflation
Inflation, as measured by the Consumer Price Index, rose at its fastest pace in six years in May. Of course, there have been numerous head fakes on the inflation front over the past decade but inflation has remained stubbornly low overall. For investors with fixed-rate investments, however, I'd put minding inflation in the category of "better safe than sorry," because inflation can eat away at the purchasing power of the income they pocket. I like the idea of including inflation-protected bonds in a fixed-income portfolio for retirees. And while stocks are by no means an inflation "hedge," they do offer investors the best long-run shot at outpacing inflation. That's a key reason that all of my model Bucket portfolios for retirees include ample equity exposure.
Do Stay Mindful of Equity Rate Sensitivity
Bonds usually get all the attention in periods of rising interest rates. But don't ignore the potential rate sensitivity of your equity holdings. Investors often use income-producing equities like REITs and utilities as fixed-income surrogates; when yields trend up, the prices of these equities often decline right along with bond prices. That's not to say you shouldn't own them; in fact, Morningstar's analysts think REITs and consumer staples, which offer higher yields than the broad market, look pretty attractive from a bottom-up standpoint today. But if you're an income-focused investor, be careful to avoid building a portfolio whose holdings all move in unison in response to interest-rate changes.
Don't Lose Sight of the Big Picture
Rising interest rates do have the potential to lead to bond losses in the years ahead, and it's wise to brace for that possibility. But as T. Rowe Price retirement-fund manager Wyatt Lee noted on a panel discussion at the Morningstar Investment Conference, "A bad year for bonds is the same as a bad day for stocks." In other words, while you'd rather not have losses in the safe part of your portfolio you've earmarked for bonds, tumult in the bond market is going to be a lot less painful in absolute terms than will a sizable downturn in the equity market. Rather than getting hung up on micromanaging risks in your bond portfolio, a better use of your time is to revisit your portfolio's core asset-class exposures. If you've been hands-off with your portfolio and have let your equity exposure drift up, it's a good bet that you're courting more risk than you intended to.
Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.