Since the mid-1980s interest rates have been declining1 and have now remained low for the past few years. These low rates have made it challenging for many investors to generate the retirement income they need to reach their retirement goals. However, a recovering economy could suggest the possibility of rising interest rates by the Federal Reserve.
When that happens is unknown, although the Fed could give an indication well in advance. One thing is certain: You should review your fixed income portfolio with your financial advisor to prepare accordingly.
What Do Rising Interest Rates Mean?
Overall, it's important to remember that rising interest rates can be a positive indication that the economy is improving - Unemployment is hovering at 6.1%, the US economy continues to expand and operating earnings on the S&P 500 remain high.1
When the economy expands at a rate that the Fed deems too high, they can use interest rate increases as a tool to tempter growth and/or avoid inflation rates that are too high. But with rising interest usually comes declining bond prices.2 It’s important to remember that different asset classes of fixed income react differently to interest rate changes, and that stocks tend to have a negative correlation to interest rates.3
Rising Interest Rate’s Effect on Fixed Income
(Click chart for larger version)
Source: U.S. Treasury, Barclays Capital, FactSet, J.P. Morgan Asset Management. Yield and return information based on bellwethers for Treasury securities. Sector yields reflect yield to worst, while Treasury yields are yield to maturity. Correlations are based on 10-years of monthly returns for all sectors. Change in bond price is calculated using both duration and convexity according to the following formula: New Price = (Price + (Price * -Duration * Change in Interest Rates))+(0.5 * Price * Convexity * (Change in Interest Rates)^2). *Calculation assumes 2-year Treasury interest rate falls 0.58% to 0.00%,as interest rates can only fall to 0.00%. Chart is for illustrative purposes only. Past performance is not indicative of future results. Guide to the Markets – U.S. Data are as of 9/30/14.
Preparing Your Portfolio for Rising Interest Rates
The first step is meeting with your Financial Advisor to review your portfolio and retirement plan, and make sure you are properly diversified across your equity and fixed income investments. This can potentially help to reduce the effects of changes in interest rates. Then re-examine how much fixed income and retirement income you actually need – things may have changed since the last time your reviewed your portfolio.
For instance, the portion of your portfolio based on dividend income may offer advantages in economic climates when fixed-income returns are declining. A study by Federated Investors found that “dividend income may provide a distinct advantage when fixed-income yields are low, the outlook for inflation is uncertain and the broader market is volatile.”4
Review the following areas with your Financial Advisor:
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Your portfolio’s exposure to different types of fixed income
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Do you have too much or too little fixed income?
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The duration of your fixed income investments
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Different ways to generate retirement income
Review Your Retirement Income Plan
Though no-one can foretell the future of interest rates, it's time to sit down with your financial advisor and review your portfolio, paying special attention to fixed-income investments and your retirement income plan. Give one of our Wealth Managers a call at (800)541-7774 to discuss your portfolio and the prospects of rising interest rates.
Sources:
1 JP Morgan Guide to the Markets
2 CNBC
3 The Motley Fool
