If the Federal Reserve ever needed an excuse to raise interest rates, it just got it. With the Trump inauguration complete, and the new Administration taking office, the Federal Reserve can now begin raising interest rates. In December of 2016, they began what will likely turn into a 1% increase over the next twelve months by raising the interest rate by 0.25%.
So, what are the ramifications of these increases? Should you really even care what the Federal Reserve does?
- Interest Rates Affect Mortgage Rates
It is no secret that when the Federal Reserve raises interest rates we also see mortgage rates increase. In fact mortgage companies are already starting to feel the pressure of a rising interest rate environment. Companies like Wyndham Capital Mortgage was reported by MPA Magazine to be laying off approximately one fifth of its employees. Expectations are, that in a rising interest rate environment, we will see home purchases decreasing and certainly refinances will also decrease. The moral of the story is, if you have an old mortgage on your home and you haven’t refinanced to a lower rate yet, now might be your last chance.
- Interest Rates Affect Bond Investments
There are two factors going on here. The first is that we have, right now, many reluctant equity investors. People and institutional money managers that have taken on more and more risk as interest rates have decreased over the last 20 years, in order to try to produce more returns. Consider bonds 20 years ago. 20 years ago you could have fairly easily purchased an investment grade bond producing more than 7% interest. Today, those same quality bonds are producing only 3.5%. So what we’ve seen is investors more likely to buy riskier lower quality bonds and to invest in equities.
The second factor is that as interest rates rise we will continue, for a time, to see investors avoiding the bond market because current bond funds will lose value as the interest rates rise. This is where floating rate bond funds, and short duration funds start to shine. The only problem is that their yield is even less attractive currently than traditional bond funds and they’re not immune to the effects of a rising interest rate environment.
Building a Portfolio in a Rising Interest Rate Environment
Ultimately, the question that has to get answered is, “How do I build an investment portfolio in a rising interest rate environment.” I’m going to break up my answer between two groups:
- Pre-Retirement Investors
Pre-retirement investors are anyone who is still contributing to their retirement accounts. Pre-retirement investors need to understand the current risk of the bonds in their portfolio, and consider utilizing cash positions as a risk hedge and well-diversified equities for growth. While interest rates are on the rise, bond investing is at risk for losses while providing less than ideal yield. Due to dollar-cost-averaging for regular contributors to their investment accounts, pre-retirement investing is likely to do relatively well even if stocks experience difficulties during this rising interest rate environment.
- Retirement Investors
Retirement investing takes on a different set of challenges. Equity investments eventually will run out of steam, and bonds will become attractive again. Higher than average cash positions, alternatives to bonds such as indexed annuities, and other safe investing strategies should be strongly considered. Equities can be held, but they should be held with a willingness to sell, or in small quantity.
Whether you are a Retirement or Pre-Retirement investor, it is unlikely that you’ve experienced investing in any time like what we have ahead of us. Interest rates are as low as they have ever been and there are serious concerns about global recession-like periods ahead of us.
Investing in today’s economy has never been more risky and less profitable. Top experts in the field of investing and finance agree that the a good average rate of return in today’s market environment is somewhere between 4% and 6% with risk levels as high as in times past, with no traditional “buy-and-hold” methods for managing that risk by allocating money to bonds that will create the same results of the past.
The net result of this is that you need to be very careful when selecting your investments. Looking to the past to predict future performance on any investment that is holding bonds is a very risky proposition. And because we’ve rarely seen how stocks react in this type of an environment, it is fair to say that we may be in for a rough road ahead.