Interest Rates Are Rising: Should I Worry?

Interest rates are on the move; so much so, that the 30-year mortgage rate is more than 4.5% (up from 3.7% a year ago). Not good for mortgage and credit card borrowers, but bond investors are elated.

Similarly, the 10-year U.S. Treasury bond pays almost 3% (last year, it was at the 2% level). This may not sound like much, but 1% can make a big difference.

While this is good for bond investors, stock investors may be as anxious as borrowers. That’s because, since the beginning of this year, we’ve also seen greater volatility in the markets than experienced in the prior two years. Why? Well, higher interest rates mean corporations’ and businesses’ borrowing costs go up, just like consumers. This concerns investors because companies will have less money to pay back in dividends and to spend on new projects. At the same time, stocks look less attractive when compared to higher bond yields. Thus, income-hungry or risk-averse investors may decide to purchase U.S. Treasury bonds rather than the latest high-flying tech stocks or any stock that pays a good dividend. That’s a big change from what we saw in the last decade.

It’s unsettling for markets, but should you be concerned? We don’t think so.

In part, because of observations from similar situations in the past:

• Historically, the Fed has often moved with speed when raising rates — surprising both the market and businesses. That hasn’t been the scenario this time around.
• Global-equity prices often rallied in both the run-up to policy rate-hike cycles as well as the year following the onset of rate increases — with the health of the economy a key consideration.
• In the U.S., large-capitalization equities frequently staged a short-term dip as investors assessed the change in environment; however, those episodes often proved to be buying opportunities.
• Diversified bond portfolios frequently turned positive within a few years, even amid rising interest rates.

What should we invest in and avoid in this environment?

First, as mentioned above, there may be some short-term volatility when interest rates increase, but over the long term, stocks tend to fare well. Thus, when we invest in stocks, we focus on the next five years; not five months. In doing so, we’ll continue with our strategy to select global stocks and weight the portfolio toward:

• securities selling at a discount to their book value
• companies with significant profitability
• small- to mid-size companies

Second, from a bond perspective, things get a little more interesting. We spend a lot of time developing our bond allocation (this asset class is often neglected in comparison to stocks and definitely warrants further attention).

Although rising rates will hurt bond prices temporarily, it will help the overall bond portfolio in future years. As Jeff Moore, a Fidelity bond portfolio manager, mentioned this week in a Bloomberg interview, “I’m actually more excited going forward than I was in the last five years. You may have a period where rising rates affect the prices, but over the course of one, two and three years, these higher yields mean that investors can increase their bond market expectations.”

As an ex-bond portfolio manager, I also can attest to the excitement in the bond world. Like stocks, in the Redwood bond portfolio, we invest in a wide variety of bonds with the goal of providing broad diversification while maximizing the interest rate you earn and minimizing the risk of the portfolio.

Here are a few examples:

• The iShares Core U.S. Aggregate Bond fund allows us to invest in U.S. Treasury bonds and other government-backed securities (like mortgage-backed securities, which are bonds backed by mortgage borrowers with high credit ratings). These are some of the safest bonds in the portfolio.
• The PIMCO Foreign Bond fund allows for investment in international government bonds issued by France, Japan, Great Britain, Germany, and other developed countries. It’s one of the best performers in our portfolio this year.
• The Schwab U.S. Treasury Inflation-Protected Securities fund protects against inflation by investing in bonds that adjust as inflation increases. Inflation is creeping up and, with unemployment at 3.9%, high inflation is a concern. These bonds will protect against this.
• Finally, the newly added DFA Global Core Plus Fixed-Income Portfolio fund adds bonds issued by large foreign corporations like BMW, British Petroleum, Molson Coors, Toyota, and other high-quality, global companies.

Our bond portfolio strategy is to spread the money allocated to this area among 5,000 different bonds. The bonds differ in maturity dates and offer protection in various economic environments; while some are down in price now (like longer-term treasury and corporate bonds), others are up (like the international and treasury inflation-protected investments).

We’re well-positioned for this rising rate environment and are glad to finally see rates start to climb.  This helps all bond investors, but especially those with higher bond allocations and those who depend on income in retirement.

As always, we are happy to discuss your bond portfolio in more detail.