Up to one-third of investors and advisors have never managed money in a rising rate environment. Many investors have spent a lot of time thinking about the challenges that the Federal Reserve's long-awaited change in interest rate policy could pose. They have been concerned about how this would affect their investments and what the best course of action is when it comes to rising interest rates. But now that it has happened, and with the expectation that the next phase of Fed policy normalization will be modest compared to previous rate tightening cycles, advisors recommend that investors develop a thoughtful plan for the future of their portfolios.
The Fed's move
The Fed's December rate hike was far from unexpected, but could mean a new investment approach is needed. The move was the first time interest rates have been raised since 2006. At the end of December, many asset managers believed that 2016 would be a good year for equity investors due to low interest rates, low energy costs and no inflation. Growth in the economy. Whether it plays out that way is anyone's guess; however, the start of 2016 has been cause for concern. (For more information, see: Federal Reserve's dual mandate is broken.)
At the same time, policymakers have conceded that future rate hikes will be gradual. Traders view the rate hike as a vote of confidence in the economy, which should bode well for corporate profit expectations. In this new environment, advisors will help clients make decisions about how best to protect their assets, increase their income and lower their income taxes.
For example, some advisors recommend that clients avoid taking on much more risk by combining strategies. And while there's no way to completely avoid risk, reducing exposure to higher interest rates is often the best bet. (For more information, see: How to Assess Your Clients' Risk Capacity .)
Bail-on bonds did not
Bond prices and interest rates have an inverse relationship. As interest rates rise, bond prices fall. This means that bonds with longer maturities are more vulnerable to rising rates because they could be held in lower rates for longer periods of time. But while some investors see shorter-duration bonds as a good solution for dealing with rising interest rates, the flip side is that these shorter-duration investments also outperform lower yields. Some advisors suggest investors focus on floating-rate securities such as bank loans and TIPS (Treasury Inflation-Protected Securities) with adjustable rates, which makes them less vulnerable to rate hikes.
Intermediate-term bonds are also doing surprisingly well during this period of rising rates, which is why advisors are cautioning clients not to prematurely bail out all of their bond funds simply because they fear rates will rise again. With only a gradual increase in expected interest rates, accompanied by a flat yield curve and low longer-term rates, these bonds continue to offer upside potential. In fact, many advisors believe that intermediate-term bond funds can handle the Fed's next rate hike cycle quite well, if not better, than during some of the more aggressive periods of rising rates that markets have experienced in the past. (See more at: How retirees should respond to rate hikes.)
Credit Risk
Rising interest rates are usually a good thing because they mean the economy is strengthening and credit risk is increasing. Rewards. For this reason, credit assets such as high-yield bonds and securitized loan portfolios are also a good option to reduce interest rate exposure in favor of credit risk. Securitized loans tend to do well without corporate exposure, as credit risk is related to equity risk and can provide a solid foundation for higher-quality holdings. This is critical when economic growth slows, many analysts believe. Below-investment-grade bonds are another option for risk takers and can serve as a welcome addition to a portfolio during times of rising interest rates. That's because they offer high income during times of economic expansion.
Because of their lower interest rate sensitivity, short-term bonds can also offer investors modest but reliable yields and high risk-return ratios. As a result, some analysts recommend unconstrained bond funds that are flexible enough to maintain an appropriate balance between credit and duration risk. In this way, they can weather uncertain times and offer a low correlation to volatile stock markets. (For more information, see: Top 5 High Yield Bond Funds for 2016 .)
Both unsecured and short-term bond funds offer the advantage of lower interest rate sensitivity while having the potential to generate higher returns. Returns for investors as interest rates rise. Overall, short- and intermediate-term bonds will be less vulnerable to rising rates in the current environment, so investors may want to reduce exposure to long-term bonds, advisors say.
REITs
In the current growth environment, investors looking for equities should consider adding real estate investment trusts (REITs) to their portfolios, some advisors say. Because of their economic sensitivity, REITs have typically performed well in rising rates, despite their volatility. As the expectation of rising interest rates continues in 2016, investors should consider investment strategies that include all those asset classes that have performed well when interest rates have been rising.
The Bottom Line
Advisors and investors have long known that a rise in interest rates is imminent. That's why it's a good time for advisors to help their clients reevaluate their portfolios to make sure they're taking advantage of everything there is to offer an improving economy.(For more information, see: Why the best time for a portfolio risk review is now.)