Fine-Tune Your Investment Strategy

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April 29, 2016


Interest rates drive a number of the factors surrounding investing, from simple bank savings accounts to home mortgages. Today’s investors have fine-tuned their strategies to fit with the historic-low interest rates of the past seven years, but now that interest rates are on the rise again, it’s prime time for re-evaluation.

 

The pace of the rate increases is expected to be modest, with the Federal Reserve (Fed) funds target reaching just 1 percent or less by the end of 2016 — and even that level of growth is not a guarantee, says Robert Haworth, CFA and Senior Investment Strategist for U.S. Bank Wealth Management.

 

Haworth explains that if inflation expectations erode, wage growth fails to materialize or economic activity slows down, the Fed could defer rate increases until improvements are seen. It’s also important to note that Fed rate actions tend to have little influence on long-term interest rates, except through inflation expectations. 

This is the primary reason the Fed engaged in quantitative easing policies — to reduce long-term interest rates. “This is not a replay of 2008, when the economy was soft and U.S. stocks fell by a third from the peak, and some international markets saw 50 percent losses,” Haworth says. “This is a different environment.”

 

The Fed has begun the first cycle of interest rate increases in a decade, which might be a bit of a shock for investors who’ve grown accustomed to an incredibly low interest rate environment — it’s been at or near zero percent since 2008.

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April 29, 2016


The economy is improving, jobless rates are down, housing is stable and consumer confidence is slowly returning, all of which could mean the Fed is comfortable with putting a little upward pressure on interest rates, says Jennifer Vail, Head of Fixed-Income Research for U.S. Bank Wealth Management. 

 

Typically, when investors see short-term interest rates rising, their gut reaction is to go much shorter on bonds because they expect the Fed to move at a rapid pace. That’s not the case this time around. “The economy is progressing modestly, and without accelerated spending, the Fed is facing no pressure to move quickly,” Vail says. In other words, increases will come slowly and modestly, leaving time for investors to make necessary adjustments.

 

The pace of interest rate hikes is also important to equities, because equities are subject to stock market fluctuations that occur in response to economic developments. “A slow glide path toward higher interest rates implies modest inflationary pressures, warranting valuations at or near current levels,” says Terry Sandven, Chief Equity Strategist for U.S. Bank Wealth Management.

“That said, there is reason for caution. Higher interest rates represent change, which often leads to increased uncertainty and overall market volatility.”

 

How to adapt to a rising interest rate environment

 

U.S. Bank advisors believe that short-term rates will rise faster than long-term rates, and the expectation is that rising rates will generally be a headwind to fixed-income investments and bond proxies, including high-dividend yields in other asset classes. With that in mind, our experts offer this advice on how to think about the shifting interest rate environment and how to adjust your portfolios accordingly. 

 

Keep to the middle. Because this interest rate hike is expected to play out on a shallow growth trajectory, going short on bonds isn’t necessarily the best strategy. Investors who heavily invest in the short-term end of the investment curve — think zero to three-year bonds — face a higher risk of reinvestment losses, Vail says. 

 

Instead, investors should consider bonds with an average maturity of five to seven years and include normal allocations to longer-term rather than shorter-term bonds.

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April 29, 2016


In this environment, supply and demand factors and nominal economic growth expectations are what set the long end.

 

This implies that the yield curve will flatten, with rates for short-term maturities rising faster than for longer-term maturities. “When you focus on the intermediate to long end of the curve, you are less likely to suffer price declines,” Vail says. Because short-term interest rates are expected to rise gradually over a longer period of time, the income on these investments can offset the decline in price.

 

Investors also might want to increase their credit exposures, as spreads are fair relative to high-quality securities, and the premium offered for lower-quality credits tends to compress in rising interest rate regimes, Vail says. She suggests sticking with fixed-income and emerging market or high-yield investments for the intermediate curve.

 

Don’t dump high-yield bonds just yet. Typically, when interest rates rise, bond prices fall. But before making any decisions, consider the income on that bond. With high-yield bonds, many investors are holding lower coupons than in the past, Vail says. As rates rise, the income from those bonds can help offset falling prices, which lessens the impact of the rate increase on a portfolio. High-dividend yield securities also tend to be seen as bond proxies and will likely lag in a rising rate environment. “As long as you can balance the income to price decline, you should be able to manage the difference,” Vail says.

Consider credit debt. Historically, credit spreads compress during rate increases, which means the premium investors earn for taking on credit risk relative to high-quality U.S. Treasury debt falls. This cycle is expected to be no different, Vail says. Current spreads for investment grade and high-yield corporate debt are fairly priced, and in some cases cheap, relative to the current economic environment and long-term averages.

 

Investment Considerations as the Interest Rate Environment Shifts

 

Consider municipals. Although the municipal bond market can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities, for long-term investments, municipal bonds can be a good choice. “Because municipalities have different income drivers and leverage from corporate debt, they tend not to behave like corporate bonds,” Haworth says. Historically, municipal bonds have traded more in line with U.S. Treasury bond prices, with a time lag. “We would expect the flattening U.S. Treasury yield curve will have a similar impact on municipal bond prices, which would indicate investors should focus on average maturities of five to seven years, or longer for certain investors.”

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April 29, 2016


Consider trying equities. U.S. Bank experts agree that in this rising interest rate environment where the pace of rate hikes is likely to be slow, it makes sense to tilt your portfolio toward equities. “Our attraction toward equities is anchored in our belief that the pace of inflation and wage gains will be moderate, the United States will avoid a recession, and future Fed rate hikes will be deliberate,” Sandven says. This effectively paves the way for sectors and companies that are growing revenue, gaining market share, and have thematic appeal to perform well. 

 

Additionally, Sandven notes that select equities afford investors both income and appreciation potential, with many S&P 500 companies offering dividends yielding above the 10-year Treasury yield. While maintaining a generally constructive outlook for equities, he points out that the risks are elevated, as is evidenced by lackluster and volatile early-year equity performance. “Active security selection is likely to be important in a year when we face national elections, the slow pace of global growth, earnings uncertainty and the aftermath of falling energy prices,” Sandven says.

Your Move? Refinancing, Hedging as Rates Rise

 

When choosing equities, Sandven encourages investors to look for companies growing revenue faster than peers while operating in markets growing faster than the economy. He notes that “companies that cater to a global consumer, are focused on ecommerce, cloud computing and online connectivity and support an aging population are among areas that seem particularly well-positioned for favorable future performance.” 

 

Cash might not be the best bet. “We believe it’s a mistake to completely avoid risk by going with cash. Rather, consider five-, seven- or 10-year bonds,” Haworth says.

 

The problem with cash is the lack of upside. You might earn a quarter of a percent on cash deposits, but when you put money into bonds, it works harder for you. “For example, consider a bond providing a 2.2 percent return with cash. That may not be much, but it is a lot higher than 25 basis points,” he says.

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April 29, 2016


Think small: Simple tweaks may be all you need

 

Small increases in interest rates merit equally small adjustments to your investment portfolio. As noted above, any changes that will occur in the coming months will likely happen slowly, so we don’t think there is a need for impulsive decision making. “The bias should be toward caution,” Sandven insists. He urges investors to look for opportunities, capitalizing on the change in trend while positioning portfolios with the end of 2016 and the beginning of 2017 in mind. 

 

“Keep an eye on changes in the economy,” Haworth adds. It is easy to watch what the Fed is doing and to track inflation rates, consumer prices, wage increases and other indicators of an improving economy, all of which will impact the Fed’s interest rate decisions.

“If oil prices move higher than $50 per barrel, or consumer prices rise by more than 2 percent year over year, those would be surprises that imply changes in the market,” he says.

 

In those cases, investors will want to revisit their investment decisions — but otherwise the average portfolio should only require slight adjustments. “These are near-term tactics to adapt to near-term market conditions,” Haworth says. “It’s not a situation where you need to change your long-term plans.”

 

And as always, Vail advises checking in with your investment advisor to discuss how the shifting interest rate environment will impact your specific portfolio plan. “At a minimum, you should revisit your long-term goals,” Vail says. “And make sure your investment house is in order.” 

 

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