Solid economic data, rising energy prices, and expectations of expansionary fiscal policy have all conspired to push interest rates higher since the U.S. presidential election. Additionally, the Federal Reserve has made its intentions for raising short-term rates clear. While the timing of rate increases is difficult to discern, our expectation at U.S. Bank is that rising rates will generally be a headwind to fixed-income investments and bond proxies, including high-dividend yields in other asset classes. With that in mind, here are some thoughts about the shifting rate environment and potential strategies to consider with your investment portfolios.
Keep to the middle. Because this interest rate hike is expected to play out on a continuation of a shallow growth trajectory, those who heavily invest in short-term instruments may run the risk of locking in low rates as the Fed moves, possibly several times in 2017 alone, to head off inflation.
As an alternative, investors may want to consider bonds with an average maturity of three to seven years and even contemplate small allocation to longer-term bonds. In this environment, supply and demand factors and nominal economic growth expectations are what set the long end. Also, U.S. yields are considerably higher than elsewhere in the developed world. This implies that the yield curve will flatten, with rates for short-term maturities rising faster than for longer-term maturities.
Investors may also want to consider an increase to credit exposures, as spreads are fair relative to high-quality securities, and the premium offered for lower-quality credits tends to compress in rising interest rate regimes. Current spreads for investment-grade corporate debt appear to be fairly priced, and in some cases, attractive, relative to the current economic environment and long-term averages.
Don’t abandon high-yield bonds just yet. Typically, when interest rates rise, bond prices fall. But before making any decisions, consider the income on a high-yield bond. As rates rise, income can help offset falling prices, which may lessen the impact of the rate increase on a portfolio. Balancing current income against prospects for price declines can be key to creating a successful bond portfolio in a rising rate environment.
Consider municipals. Since the election, municipal bonds have suffered, from both the shift upward in yields, but also the expectation of lower tax rates in the years ahead. For taxable investors, particularly those in higher brackets, the after-tax return potential of municipals compares very favorably with other possibilities. Historically, municipal bonds have traded more in line with U.S. Treasury bond prices, with a time lag. With an expectation of a flattening yield curve, taxable investors should also consider average maturities of three to seven years.
Hedge your bets. As prices of bonds fall in a rising rate environment, the ability to “short” the market becomes attractive. Once the realm only of sophisticated hedge funds and institutional investors, hedged fixed income has become more accessible over the past several years. Some professional managers offer products that combine high-yield bonds along with short positions with the objective of achieving solid yields with less interest rate risk.
Consider equities. In a rising rate environment where the pace of rate hikes is likely to be slow, it may make sense to consider a larger allocation of your portfolio toward equities, both in the U.S. and abroad. The equities attraction is anchored in our belief that the pace of inflation and wage gains will be moderate, the United States and other developed markets will avoid a recession, and future central bank rate hikes will be deliberate.
Equities also afford investors both income and appreciation potential. Adding to this appeal is that tax rates - for many investors - on dividends are lower than tax rates on bonds. While the general outlook for equities is constructive, some caution is warranted, as risks are currently elevated. Active security selection is likely to be important in a year when we face high fiscal policy expectations, earnings uncertainty and continued volatility in energy prices.
When choosing equities, investors may be well-served to consider companies that are growing revenue faster than their peers, while operating in markets growing faster than the economy. Companies that cater to global consumers, are focused on e-commerce, cloud computing and online connectivity and support an aging population, are among areas that seem particularly well-positioned for favorable future performance.
Cash might not be the best bet. The problem with cash is a lack of upside. You might earn a quarter of a percent on cash deposits, but when you put your money into bonds and stocks, it will work harder for you. For example, an intermediate term bond earning 2.5 percent may not seem like a lot, but it is higher than current cash returns.
With the increased emphasis on transparency, it is easier than ever to watch what the Fed is doing and to track inflation rates, consumer prices, wage increases and other indicators of an improving economy. All of these factors will impact the Fed’s interest rate decisions. If the data continues modest improvement, as expected, the average portfolio should only require slight adjustments.
As always, a periodic review of investment goals and long-term objectives is time well-spent. Ensuring investment portfolios are aligned with those goals will help provide the best opportunity to achieve long-term success.