With IRs at extremely low levels, retirees have had to go far afield to lift income from their savings.
But as the economy falteringly recovers, the Federal Reserve is crawling closer to raising interest rates. Because markets regularly move in advance of events, now’s the time to do a little homework and take inventory of how interest-rate increases could affect your portfolio, especially areas where you’ll have reached for extra yield.
On the positive side, higher short term rates will supply relief to savers earning a measly 0.03% on money-market funds or less than two percent on short-term U.S. Treasurys.
The downside is that higher rates mean lower bond costs and potential losses for stockholders who acquired bonds funds in the past year. But losses could show up in less clear places, such as preferred stocks.
Many speculators have more interest-rate risk than they most likely realize and in places they don’t understand. Gauging the risks posed by rising rates isn’t an easy task even for monetary market pros. These are some tips on where to look — and what to look out for.
The 1st stop for any bond investor is a statistic called duration. It reduces down to a simple rule : The longer the duration, the more delicate a bond or bond fund is to changes in rates. A U.S. Treasury ten year note, for example, has a period of 7 years, that means its price will likely fall by 7% should interest rates rise one percentage point.
But there are nuances to duration. Chief among them is that when comparing differing kinds of bonds,eg Treasurys and investment-grade corporate bonds, the same level of duration does not imply the 2 will respond identically to rate changes. In the case of corporate bonds, it’s in part because prices also are influenced by the credit quality of the company.
And if that were not enough, the same types of bonds can respond differently to rate changes in different environments, mainly based mostly on the relationship between their yields and U.S. Treasurys. For instance, if the opening between Treasury and corporate bonds increases at the same time that rates are rising, financiers will suffer bigger losses than if spreads are shrinking.
Remember in addition to duration, investors should look back at previous times of Fed rate increases for an idea of how an investment performed. In early 2004, the Fed signaled a rate hike was on the way and by mid-May the index slipped more than 2%.
For a rather more serious stress test, financiers should look to 1994 when the Fed began what turned out to be the most assertive rate hikes of the past two decades. That year, the index lost about 6% between Feb. Two and mid-May.
High-yield bonds, known as junk bonds, might be the exception to the rule. That is because junk-bond prices tend to be closer linked to the destiny of the company issuer and the stock market than to changes in IRs.
Sometimes, high-yield bonds have fared moderately well when interest rates rise. The explanation : a better economy, while leading to increased rates also increases the possibilities that an issuer will not default.
A favored destination in the stock market today for yield-hungry financiers has been preferred securities. Many financiers do not realize that preferreds are a cross-breed of stocks and bonds. In fact , they reply to rate changes more like long-term bonds than stocks. Between late Jan and mid-May of that year, the SP preferred index was down more than 12%.
Another high-yielding destination vulnerable to rising rates is closed-end funds. Many use borrowed money — leverage — to magnify yields. But higher rates can make leverage less profitable.
Closed-end funds invest in a selection of investments, not just bonds suggest the latest stock market analysis. But closed-end bond funds can be especially vulnerable to a squeeze on their leverage. The rationale is that many rely on a strategy of borrowing at low rates and making an investment in higher yielding longer-term debt. In the past year, the opening between short- and long term rates has been phenomenally giant.
That gap is likely to shrink when the Fed tightens. As a result you’ll basically see declining yields on some closed-end funds. That in turn, he is saying, is likely to come with falling share prices.