Rising Interest Rates, Rising Skepticism

It’s no secret…US interest rates are on the rise. It’s about time considering the Fed Funds rate has been at an all-time low for nearly a decade. The recent turmoil has been fueled by, at least partially, headlines of rising interest rates and inflation. With the equity markets at all-time highs and interest rates at all-time lows, to think interest rates had anywhere to go but up is ill-conceived.

BREAKING NEWS: Interest rates will slowly return to historically normal levels and inflation is expected to remain within the normal range experienced all throughout modern US history.

I seriously doubt the above headline would sell any papers or garner any clicks online. Why? Maybe because it is the truth or maybe because it is about as plain, boring, vanilla as it gets! Whatever the reason, take a look at the below chart to get a feel for how current interest rates compare to historicals and how the stock market reacted to past rate hikes. Markets still prospered and the economy didn’t crumble into oblivion. Since 1976, there has been a period of rate increases about once every five to seven years. Most recently, we went without a single rate hike of more than 0.10% from June 2008 to January 2016.

Source: (Fed Rate) https://fred.stlouisfed.org/data/FEDFUNDS.txt,

(S&P 500) https://finance.yahoo.com/quote/%5EGSPC/history

The purpose of this post is not to venture down the dark path of guessing what the Fed is brewing up next or what global economics are at play here. The goal is to educate our readers about how we can mitigate the effects of rising interest rates and a worried stock market in a diversified portfolio of equities and fixed income securities.

When the stock market shows signs of shakiness, investors might look to bonds to protect their principal in exchange for an often smaller, but safer return on their investment. Bonds have historically provided downside protection from the stock market but the economics at work today are unique. With interest rates on the rise, bond prices are now at risk of losing value at time when investors may be looking to pare back equity exposure in their portfolios after a booming 2017. There is no perfect move in this situation because we unable to control the market’s performance and we are unable to control the Fed’s next move. What we can control is the correlation of our bond investments to the stock market and our exposure to interest rate risk.

Correlation

We all hear the term diversification in investing. In loose terms, diversification is a risk management technique involving the use of different investments to reduce exposure to risks associated with any single investment. Correlation between investments is the underlying concept at work when diversifying a portfolio. Correlation is a value comparing the performance relationship between two investments. It can range from +1 (perfect correlation) to -1 (perfect negative correlation). If two investments are perfectly correlated, their value will increase or decrease in tandem. If two investments share perfect negative correlation, their value will always move in opposing directions.

While diversification does not guarantee a more profitable portfolio, it can help an investor protect their investment returns in the event of market extremes.

Duration

Unlike diversification and correlation, duration is a term exclusively related to bonds and is measured in terms of years. Although we may use bonds to diversify a portfolio, duration is used as a measurement of a bond’s sensitivity to changes in interest rates. The greater a bond’s duration, the greater an investor’s exposure to interest rate risk. In theory, for every 1% change in interest rates, there is an equal and opposite change to a bond’s price of 1% for every year of duration.

The above relationship between interest rate changes and duration is for illustrative purposes only.

With interest rates on the rise, there is much concern over losing value in bonds. In the above example, if an investor owns a bond fund with a four year duration, they can expect to lose 4% if interest rates increase by 1%. This is a very real possibility considering the Fed’s recent rate hikes. Although on the surface principal may be lost, let’s not forget the investor is still earning coupon payments. Consider the below example:

The above relationship between interest rate changes and duration is for illustrative purposes only.

We don’t expect a 1% return to make anyone rocket out of their seat in excitement but this example serves to show investors may not lose ‘a ton of money’ by investing in bonds like some other sources out their might indicate in this economic environment. Sure bond investments today come with the ever-prevalent interest rate risk but they can still be an effective asset when seeking diversification.

With the markets experiencing greater volatility in 2018 than we’ve been accustomed to seeing in the past 3 years, it is now more important than ever for investors to re-evaluate their portfolio’s risk exposures. Give us a call if you would like us to take a look at your current portfolio.

The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. Securities offered through Securities America, Inc., member FINRA/SIPC, Betsy Merritt & Tyler Aubrey Representatives. Advisory services offered through Securities America Advisors, Inc. New Break Financial and Securities America are separate companies. Securities America and its representatives do not provide tax or legal advice. It is important to coordinate with your tax or legal advisor regarding your specific situation. Diversification seeks to reduce the volatility of a portfolio by investing in a variety of asset classes. Neither asset allocation nor diversification guarantee against market loss or greater or more consistent returns.