Strategies for Clients in Rising Rates Environment

The Federal Reserve voted in June 2018 to approve a rate increase – the second one this year – and indicated two more increases will be coming before the end of the year. Of course, there is some speculation that a fourth hike in December won’t happen, partly because the Fed will have less room to move due to the dovish stance of many of its global counterparts. There are also concerns that a hawkish central bank could invert the government bond yield curve, signaling a recession. 

Whether there are one or two more hikes this year, any time there are rising rates it creates risks for investors. Fortunately, there are several time-tested strategies that can help investors protect their portfolios – and even profit – during a rising rates environment.   

Investors can sell some of their bond holdings and put the proceeds in money market funds, certificates of deposit (CD) and other interest-earning cash accounts that have the potential to benefit from rising rates. This strategy works because as interest rates rise, so should the earnings on any cash or money market instruments. This is the simplest (and most extreme) strategy an investor can use when it comes to playing rising rates.  

Another play is to reduce long-term bond exposure while moving into short- and medium-term bonds. Shorter-term bonds are less sensitive to rate increases, and they almost always pay a higher interest rate than cash or money market accounts – but they do provide less earnings potential than bonds with longer maturities.

To address this, investors can pair short-term bonds with other instruments like Treasury Inflation-Protected Securities (TIPS), which are less sensitive to rising rates than other fixed-rate instruments – they’re adjusted twice a year in response to the U.S. Consumer Price Index (CPI). TIPS are considered by many to act as a portfolio’s ballast. Several ETFs offer easy, convenient access to TIPS, including iShares TIPS Bond ETF (TIP), Pimco 1-5 Year TIPS Index ETF (STPZ), Schwab US TIPS ETF (SCHP) and Vanguard Short-Term Inflation-Protected Securities ETF (VTIP).

A common investment strategy is a bond ladder. With a bond ladder, an investor buys a series of treasury bonds, munis or investment grade corporate bonds that mature at regular intervals over the course of several months or years. The main reason to use a bond ladder is to avoid being locked into one particular bond for a long time – something that would be detrimental during times of rising rates. Instead, as each bond in the ladder matures, the proceeds are rolled into a new bond farther out on the bond ladder – ideally, at the new, higher rate.

Rising interest rates can be a risk for bondholders, but they can also mean trouble for stock investors. Rising rates tend to have a negative influence on stock prices, partly because of the increased cost of capital companies face when rates rise. There are several sectors in the equity space, however, that generally benefit from rising interest rates – and these are good areas for clients to focus on now. The financial sector, which includes banks, insurance companies, investment funds and real estate firms, benefits from rising rates. That’s because rising rates signal a strengthening economy.

For banks and other lenders, that means borrowers are more likely to make loan payments – which means fewer non-performing assets​​​​​​​ (NPA) for the bank. For investment firms, that’s good news because a healthy economy means more people investing more money. Insurance companies can see an uptick in business since improving consumer sentiment means more big purchases – like houses and cars – which leads to more policy writing.

Other sectors that benefit include consumer discretionary, consumer staples, industrials and real estate. Also, since the price of raw materials tends to remain stable or decline when interest rates rise, companies that use these raw materials to produce a finished good can see a corresponding uptick in profits as their costs drop. Because of this, companies that use raw materials – either to produce a finished good or in their daily operations – may make good investments during periods of rising interest rates. 

Since a house is typically the largest single investment a person ever makes, it makes financial sense to pay close attention to mortgage and refinance rates when the Fed is hawkish. Those who are thinking about buying a home – or who already have a variable-rate or adjustable-rate mortgage – should consider locking in a mortgage or refinance before rates rise further. This doesn’t mean it’s time to hit the panic button and settle for any house just to get a mortgage, or opt for a refinance without doing a thorough cost-benefit analysis. Still, even tiny interest rate changes drastically affect the cost of buying a home, so it pays to be aware of the rising rates, and plan accordingly.