With the economic recovery taking hold, many market watchers foresee an inevitable steady rise in interest rates. About three years ago, in an effort to stimulate economic growth, the Federal Reserve began purchasing long-dated government bonds and mortgage-related bonds; thereby, forcing down long-term interest rates – a program known as “quantitative easing (QE)”. The anticipation of the Fed beginning to taper its bond-buying program has already resulted in a broad-based rise in yields and decline in bond prices.
But the reality is that the Federal Reserve is likely to change policy very slowly and only as they see clear evidence of sustained solid growth. Some investment advisors believe that job growth would have to improve from its recent monthly pace of approximately 170,000 for the Federal Reserve to curtail its purchases. With fiscal austerity hitting the economy, including both tax increases and spending cuts, the Fed might not announce a change in the pace of its purchases until the end of 2013. That means that the recent surge in bond yields might not be sustained.
It is probable that the yield on the 10-year U.S. Treasury note, which stood at 2.93% as of September 11, 2013, to rise further in 2014, although there may be some decreases along the way. Their target for the end of 2014 is 4.00%. But even small increases in yield could have an effect on our investment portfolio as well as other assets. Additional inflation, is what some fixed income strategists, call the “great enemy of bonds,” could also eventually become a concern.
The following are some steps that we can take to prepare for the potential impact of rising interest rates:
1. Reallocate.
Based on our specific risk profile, we can potentially reduce some of our bond allocations as part of a short-term (12 – 18 months) tactical strategy in favor of equities. We can then supplement the resulting reduction in income, or possibly even increase our income, by looking for dividend growth stocks – companies with a solid track record of regularly hiking their dividends. It’s critical to work closely with our financial advisor, who can suggest an allocation strategy based on our investment profile, risk tolerance, liquidity needs and long and short-term goals.
2. Shift.
The longer a bond’s duration, the less attractive it will be when interest rates rise. That’s because it will pay less income than newer bonds pegged to the higher rates, and do so over a longer period of time than shorter-duration bonds. Therefore, consider shifting the durations of the bonds held in the portfolio – buying those with shorter-term maturities and selectively selling those with terms longer than ten years.
One option is to create a bond ladder – purchasing an assortment of bonds that mature at different intervals. As each bond matures, proceeds are reinvested in the longest-duration security. By reinvesting the proceeds at the current interest rate, we build a portfolio that has an increasing yield as rates rise – leading to the potential for higher total returns. This strategy can potentially be beneficial for those that take advantage of the higher yields that one generally get with longer maturities, without taking an undue amount of interest rate risk.
3. Diversify.
Shifting long-term bond allocations may result in reduced income. To offset that, you look to certain other types of fixed income. For example, “high-yield corporate bonds” can be attractive in an environment where the economy is in a solid recovery, since that should make it more likely for companies to meet their debt obligations. Also consider professionally-managed bond mutual funds, which enable us to invest in several different bonds and debt securities with one selection, or securities with exposure to interest rates, such as Treasury Inflation Protected Securities (TIPS). ‘TIPS’ is a type of government bond that provides protection against inflation, along with twice-yearly interest payments, inflation is always a concern for bondholders because rising prices would threaten the purchasing power of the income that a bond provides. With ‘TIPS’, the principal value rises with the Consumer Price Index (CPI) and your interest payments fluctuate accordingly. When a ‘TIPS’ matures, you are paid the greater of the adjusted principal or the original principal.
In reality, asset allocation and diversification do not ensure a profit or protect a loss in declining markets. Nothing does. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments, which are predictable if you watch for the change in indicators.
When interest rates go up, bond prices typically drop, and vice versa. Income from investing in municipal bonds is generally exempt from federal and state taxes for those in the issuing state. While the interest income is tax exempt, any capital gains distributed are taxable to the investor that is not tax exempt. Currently we are a 501(3) (c) charity on the Foundation side but not the Fraternity.
Investments in high-yield bonds (sometimes called “junk bonds”) offer the potential for high yield short term current income and attractive total returns, but it involves certain risks, such as changes in economic conditions or other circumstances, that may adversely affect a ‘junk bond’ issuer’s ability to make principal and interest payments.
Analysts agree that the next rise in interest rates is likely to be gradual over a long period of time. While we may have some time to consider and develop an investment strategy that makes adjustments to offset the risk that rising interest rates would have on any investments that we may have in bonds, it is important to work with our financial advisor to identify the best strategies to meet our goals.
This is not rocket science; however, we cannot afford to keep doing the same old things the same old way; getting the same old results is no longer an option. We must make changes and move into the modern age – making informed decisions based on the best information that we can get. For the future of our scholarship program, we must be “Always Faithful” and continue to “Be A Builder”: failure is not an option.
Ken Dyer
Grand Master
