Some market pundits have sounded alarms over expectations for increasing interest rates.
A continued increase in interest rates could affect portfolios. But the scope of the impact depends on how fast and how much rates rise, and most indicators point to a slow and steady increase from current levels.
Interest rates have varied significantly throughout time, trending up until the early 1980s and trending down ever since.
For example, the 30-year fixed mortgage rate peaked at more than 18 percent in late 1981, and then declined for the next 30 years, reaching an all-time low of just over 3 percent in 2012.
Looking at the 30-year mortgage rate since 2012, the rate has not varied significantly and has recently started to increase from the record lows of the past couple of years.
Both economic growth and high inflation contribute to rising interest rates. Although the economy has been recovering, mediocre new job creation and other economic data has pointed to less-than-optimal growth.
We’re also currently in a period of very low inflation, with the last two years averaging well below 2 percent per year and expectations of between 2 and 2.5 percent inflation through the next decade.
These two factors indicate that the concerns of rapidly increasing interest rates are overstated. However, no matter how quickly rates rise, it’s smart to understand how increased interest rates could affect your portfolio.
Bonds
To estimate the impact of a projected slow increase in interest rates on bond returns, we reviewed the most recent period when the 10-year Treasury rate increased slowly over a number of years. From Jan. 1, 2004, through June 1, 2007, the 10-year Treasury rate rose from 4.26 percent to 5.03 percent, which is fairly comparable to the magnitude and duration of the increase we anticipate in the near term.
When we looked at the total return earned by the Barclays, U.S. Aggregate Bond Index during that time period, it did not lose money; it actually averaged a 3.6 percent annual gain.
Why?
Although bonds do lose principal value when interest rates rise, they benefit from increased yields from the coupon, offsetting the initial loss of principal.
If you are still concerned about bond performance, one strategy is to reduce risk and lessen the impact of changing interest rates by “laddering” bond investments.
By purchasing bonds that mature at different times — such as one, two and five years from date of purchase — you can take advantage of the potentially higher rates offered by newly issued bonds as each bond matures.
However, this strategy would not protect you against the risk of default and you may lose money if you sell the bond before maturity.
Stocks
Rising interest rates are generally not good for equities, but tend to affect some industries more than others.
Higher interest rates may limit consumer spending, which in turn affects the housing and automobile industries.
Additionally, when interest rates rise, companies pay more to borrow money, thus reducing earnings. And higher yields may encourage investors to put more money into bonds and less into stocks.
High dividend-paying and preferred stocks, in particular, generally perform poorly in a quickly rising rate environment.
However, the effect of rising interest rates, especially slowly rising interest rates, may not be noticeable in a strong stock environment.
In 2013, the 10-year Treasury rate rose 1.18 percent while the S&P 500 index still returned gains of over 32 percent.
Diversifying For Portfolio Performance
At my firm, we anticipate that interest rates will increase at a slow pace. We believe that portfolios that are diversified across asset types and holding terms can help your assets withstand market fluctuations.
Erin Eddins works for StanCorp Investment Advisers. She can be reached at erin.eddins@standard.com, 425-212-5986 or visit her company’s website at www.stancorppugetsound.com.
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