Thoughts on rising interest rates & viable ideas
January 18, 2023
I realize the following statement will not be mistaken as some sort of Nostradamus’ quote, but not all investors or financial experts are seeing the future the same way. Our decisions can be influenced by our own predictions, perhaps even altering our true long term plans or strategies. If you have an opinion on inflation or interest rate direction, no matter how extreme or centered, you can find an expert to back your view and consequently justify your actions. Rather than allow your financial success to rely on prophetic accuracy, I would suggest going back to the basics and identifying the long term purpose and strategy of your invested assets. Growth assets (stocks, MLPs, real estate, businesses, etc.) typically comprise higher risks in order to provide larger growth opportunities. Individual bonds sometimes provide lower yields in return for more predictive principal protection. The left hand often performs more effectively when working in accord with the right hand and vice versa. Having two left hands or two right hands may not provide ideal coordination. In financial terms, appropriate asset allocation may provide a more ideal risk/reward balance.
My personal forecast suggests huge headwinds to significantly higher interest rates remain embedded in the economy and just as we experienced last year, interest rates may be slightly higher but not historically high. However, as I suggested above, there is no reason for financial success to depend on precision forecasting. If interest rates are to rise, there are some helpful reminders when making investment choices:
- The primary focus/purpose for the portfolio’s fixed income allocation is often capital preservation.
- With higher inflation data releases, we have heard mantras such as “real return” or “real rates.” Fixed income allocations are about “real principal” return. A 20% stock market pullback means that 20% of your principal tied to those stocks is gone. It only comes back if/when the stock price returns. During a market shock, an individual bond may have a moving market price, but when held, the shock has zero effect on the income being earned, zero effect on the cash flow and zero effect on when the face value (principal) will mature in full (barring any default). This is a call out for diverse portfolio functions and the appropriateness of keeping allocations in growth and wealth preservation assets (the left hand working with the right), not eliminating one or the other based on the current moment or future predictions.
- If interest rates rise, the often secondary purpose of individual bond’s benefits: greater income opportunity.
There a many other considerations to keep in mind if you believe interest rates are on the rise. I have listed a few below:
- Interest rates, even with the most recent push higher, are still historically very low. You are not being paid to take on interest rate risk or extending out in maturity. At the same time, spreads (the difference between a bond yield and a corresponding Treasury yield) are compressed. You are not being greatly rewarded for taking on credit risk. As such, high quality low duration bonds structured in short to intermediate ladders may provide an ideal interim strategy. If or when rates rise, the portfolio is in a more ideal position to take advantage of the change. Consider Treasuries and CDs for very short investments, corporates in the short and intermediate range and muncipal bonds in the intermediate maturity range. This can provide diversified product types with short and consistent reinvestment opportunities.
- Preferred securities tend to have long or perpetual maturities. Although preferreds have provided very successful income boosts during an overall low interest rate period, they may be very price sensitive should interest rates rise in a substantial manner. Price sensitive investors may consider redirecting funds allocated to preferred securities.
- Look for isolated opportunities. Our trading desk often finds “story” bonds or situations that may not be mainstream but the particulars may provide additional income opportunity. These occassions may be a specific municipal or corporate issue structured and/or priced to fit the high quality, low duration target with a better yield, favorable cash flow, potential upgrade, etc.
- Fixed income has benefited with favorable total returns for decades because interest rates have been in a general interest rate decline for 40+ years (as interest rates fall, prices rise). Total return is the income received plus capital appreciation. When interest rates begin to rise, capital appreciation will disappear and be replaced by capital depreciation. Total returns on fixed income going forward may not compare as favorably. For buy and hold investors in individual bonds, capital appreciation or depreciation ultimately does not change the effectiveness of an individual bond’s principal protection or its known income. However, it may have a more impactful meaning to packaged fixed income products where bonds are not necessarily held to maturity and managers may be forced to sell bonds at an unfavorable market price. A changing net asset value (NAV) can put an investor’s principal can be at risk. In a rising rate environment, individual bonds provide principal protection unlike a protection that can be offered by many other product types.
Investing always involves risk and you may incur a profit or loss. No investment strategy can guarantee success.
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