For several months, the Federal Reserve Board has hinted that it will begin to raise the target range for the federal funds rate when it sees progress toward its objectives of maximum employment and 2 percent inflation. Many experts believe that rate hikes are likely to begin before the end of the year.
Over the past few years, low interest rates have stimulated spending and growth by making it cheaper for banks to lend money. Low rates enable consumers to borrow more for large ticket items such as cars and homes, while companies invest more in their operations and create jobs. However, when rates remain low for an extended period of time, companies may overextend and invest in less productive ventures that don’t necessarily increase productivity. Furthermore, when consumers buy more goods, manufacturers are inclined to raise prices, which can then lead to inflation. This means the Fed raises and lowers rates in various cycles in reaction to market conditions; there’s no “ideal” rate with which to maintain economic stability.
This fluctuating environment also offers opportunities for investors to adjust their portfolios to profit from – or avoid losses – due to changes in interest rates. For example, short- and long-term fixed-income investors might want to prepare for the opportunity to increase their monthly incomes, while others might wish to rebalance and diversify to protect stock market gains.
When interest rates rise, bond prices fall. Because bonds typically pay a fixed coupon, holding onto a bond may net the same level of income. However, the value of the bond will drop compared to new bonds on the market that pay a higher coupon rate. The best way to mitigate the impact of fluctuating interest rates on bond values is through a strategy called “laddering,” which involves holding a variety of bonds with different durations, such as 2, 4, 6, 8 and 10-year bonds. In doing so, every couple of years when a bond matures, you can reinvest the proceeds into another bond at the current prevailing rates – helping ensure you’re never shut out of a high-yield period or fully locked into a low-yield period. This same strategy can be applied to CDs.
For bond fund investors, the fund’s value could drop when interest rates rise. However, as the fund acquires new bonds with higher yields, your payouts will increase, which can compensate for the loss of overall value.
Stock investors, on the other hand, need to look at other sectors when interest rates rise. The most obvious to benefit from increasing interest rates is the financial sector. This is because rising interest rates expand the profit margin for lenders. The insurance sector also benefits because they can earn higher returns on the same level of premiums they collect from policyholders.
Beyond the financial sector, consumer discretionary and consumer staples sectors tend to return well during the early stages of a rate hike, as it is generally a clear indicator of rising employment levels, wage increases and job security. Tangible assets like gold and other precious metals are prudent investments in a higher interest rate environment because they offer a hedge against a pickup in inflation. While natural resources such as oil prices might drop in a high-interest environment, it’s not a bad idea to invest in stocks of companies that consume them instead of direct investments.
Despite years of low interest rates, the rate of home ownership in the United States is still quite low, especially for the Generation X demographic. These young adults were hit hardest by the recession because it prevented many from “trading up” once they had children and were poised to enter their mid-career earning years. Compared to same-aged households 20 years ago, this generation is 4 percent to 5 percent lower in home ownership rates.
However, while rising interest rates could further hamper new homeowners from applying for mortgages, they offer profit opportunities for homebuilders and construction companies in the real estate sector.
A change in the direction of interest rates impacts a variety of investment opportunities, so it’s important to re-evaluate your portfolio in light of rising rates. It might be worth considering alternate options and/or further diversifying your holdings. Check with a professional to guide you through this process.