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What Rising Interest Rates Mean for You?

Monday, November 16, 2015

Sheila Jamison and Rich Jamison

The Fed is going to raise interest rates. When they will do so is still uncertain. Rates have never been this low for this long since the Fed was created.

Since the 1950s, the rate has run from 0 to 20% (in whole numbers). Cutting out the extremes (late 70s and the last 7+ years), it has averaged a tad below 5%. (That is, if there is such a thing as a “normal” or “average” Fed rate).

When Will It Be?

We think October’s outstanding employment report will let the Fed begin to raise rates in December – despite the emergence of several subsequent disappointing economic reports. Though the data are mixed, they still point to an overall growing US economy. Based on what Chair Yellen has said, it will be for a quarter of a point. When next and how often is up for grabs.

Market Impact

Some investors are treating the upcoming rise as Armageddon for the markets. Others are anxiously awaiting the opportunities they bring. Still others say that the rate hike is already priced in.

Bonds

It is impossible to predict exactly how bond markets will respond when the Fed begins raising rates. There are lots of prior rising-rate periods to look at to see what happened. But our current situation is unprecedented. We have no comparable prior period to look at. We’ve often pointed out that past performance cannot guarantee future results. However, that statement is even more prescient now.

Rising rates produce headwinds for bond performance. Bond yields and bond prices move in opposite directions. Rates are likely to increase at a measured pace. The pace of the increase influences the pace and magnitude of bond price changes. The pace and magnitude also depends on whether we’re evaluating individual bonds or bond funds.

Two Sides

Thus rising interest rates are a double-edged sword for fixed income investors. On one edge, they entail price declines for existing individual bonds. On the other, they provide opportunities to reinvest proceeds generated from older bonds into new bonds with higher yields. That second edge works if 1) the current bond is near maturity or 2) you can get a reasonable price for the current bond. It’s not so good if 1) you have to hold the bond for a long time at a low rate until maturity or 2) sell it at a significantly reduced price to get the cash for the new bond.

Bond Funds

Bond funds have a higher risk, so much higher that FINRA posted a warning for them. Click here to read it - especially note the potential 15 and 26% losses cited in paragraph 4.) Keep in mind that FINRA never got into the “advice” aspects of anything before this!

Why do bond funds carry higher risk than individual bonds? First, most bond funds are leveraged. That means that they pay interest on the money they borrowed to buy the bonds for the fund. In turn, that means lower returns from the fund to the investor. Lower returns make the funds less attractive which pressures the funds’ prices. They just isn’t worth as much if they don’t give as much back to the investor. Second, investors clamoring to sell a bond fund force the mangers to sell the bonds in the fund at the reduced bond prices in order to meet redemptions.

Preferred Stock

Technically, preferreds are stocks. But they trade like bonds. Most preferreds have no maturity date (called “perpetual”). Those few with maturities are usually many decades in the future. Prevailing interest rates establish the value of the preferred. As rates rise, that value drops. You will get the same cash flow, but your portfolio value will drop. And if you need to sell the preferred to raise cash, you will get less for them.

Fixed Income’s Bottom Line

In short, your situation likely differs from the next person’s. While some of the above guidelines are more universal than others, generalities won’t cut it. You need to evaluate your specific position.

How about Stocks?

Rising rates in the US with falling rates in much of the rest of the world create implications. Among them, it suggests the dollar will continue to strengthen. This will keep pressure on commodities and precious metals. It means higher prices in international currencies for goods exported overseas. It means currency risk for investment in international stocks.

Generalities for Stocks

As with bonds, generalities should not be universally applied. Some guidelines are more often true than others. Be careful of the more restricted applications.

For example, the rising dollar and increased costs for exported goods suggests that smaller companies – those doing all or most of their business domestically – will be in a better position. Fluctuating exchange rates won’t make their goods more expensive here than they are now. However, they must compete with imported goods that may suddenly carry lower US prices.

For our exporting companies, there is also the consideration of lower costs for imported components. There is a balance of component cost savings versus discounting the international selling price to compete with overseas-based competitors. Are there enough ‘cost of goods’ savings to sell them at a lower, more competitive international price and still make a profit? (In some cases, this could be a larger profit than currently.) But will this mean lower top-line revenue despite better bottom-line earnings? And will this mean lowered forward guidance?

As with analyzing the bond portion of your portfolio, individual situations require individual analysis. You need to evaluate your stock portfolio with the same care and discretion.

Beyond the Dollar

Rising rates point immediately to the dollar’s strength against other currencies. But there are other things that will also occur. That is, even if we balance out all of the considerations above, something else may come into play. For example, let’s look at just one of these.

Credit Quality Deterioration

U.S. corporate defaults recently hit a four-year high. At the same time, speculative-grade (i.e., “junk”) bond defaults rose to 2.5% from 2.1% in the prior quarter. Though this ranks as modest historically, Moody's expects defaults to continue to rise to 3.8% by next October.

This adds another dimension into our evaluations. It is merely an example; not the only extra factor to consider. There are others.

What’s My Next Move?

Once again, your portfolio – what you hold now, what you are considering buying – is unique to you. Your best course of action is similarly unique. It depends on your needs – your specific goals, your time horizon, your cash-flow requirements, your need for a peaceful night’s sleep (technically, your risk tolerance) and other items that may not apply to anyone else.

If you would like our thoughts, we’ll be happy to review your current situation with you and provide our answers for your consideration. Feel free to give us a call to discuss anything that may concern you. And please pass this along to anyone you know who may benefit from the information above. We’d be delighted to talk with them, him or her too.

Sources:

Does the S&P have enough ‘juice’ to reach new highs? Simon Maierhofer. MarketWatch.com. June 17, 2015.
Effective Federal Funds Rate. FRED Economic Data. research.stlouisfed.org. November 2, 2015.
Federal Funds Data. Federal Reserve Bank of New York. apps.newyorkfed.org. Retrieved November 15, 2015.
Fixed income. A SILVER LINING TO RISING RATES? Andrew McCormick and Richard Wagreich. T. Rowe Price Price Point. July 2015.
Weekly Commentary. Russ Koesterich. BlackRock. November 9, 2015.