How rising rates could affect your portfolio
Stocks have been tanking on escalating trade tensions with China and concerns about slowing global growth. Rising rates only add to the anxiety. The 10-year Treasury yield recently jumped above 3.2% from 2.9% a month ago. That’s a big move in bond terms, and it occurred while stocks have been falling — a sign that bonds aren’t acting like the safety net investors have come to expect. Rising yields aren’t just hurting financial markets; borrowers taking out a mortgage or other loan face higher costs, too. With all this in mind, here’s a primer on the impact.
The obvious way to protect your portfolio is to sell stocks and bonds, hold more cash, and add assets, such as gold, that typically do well when interest rates and inflation are rising. But before investing in a gold-smelting kit, take a step back: Market turbulence shouldn’t derail your long-term asset allocation, although you might want to tweak it.
Higher yields are a function of bond prices falling. That has been happening since the Federal Reserve started nudging up short- term rates as it “normalizes” monetary policy. Longer-term rates are influenced by factors such as expectations for inflation and economic growth, corporate credit quality, and demand for fixed-income securities by U.S. and foreign investors.
Long-term bonds remain a risky bet. The longer its maturity, the more a bond’s price falls as rates rise. The 30-year Treasury has lost 10% after interest payments this year. Yet the broad U.S. bond market, while under pressure, has remained relatively stable, down 2.6% on a total return basis, including interest payments.
Investors who stuck with short-term U.S. corporate and government bonds have earned less than 1% this year. Corporate high-yield bonds are up 1.9%, and high-yield municipal bonds are having a banner year (relatively), up an average 3.3%.
Rising rates are a headwind for stocks, too. Steeper rates raise the cost of capital (debt or equity), and lower expected returns, pressuring price/earnings ratios and other multiples. Investors also start to weigh the impact of higher rates on the economy, pricing in slower growth and the potential for a recession if rates climb too far, too fast. Steeper rates give the economy less wiggle room, making it more vulnerable to an external shock like a trade war.
Bonds might still help preserve capital. But with the Fed boosting rates and other pressures bearing on the market, the days of bonds going up as stocks head lower are probably over. “Don’t rely on the bond market to be a great hedge if we get a stock market decline,” cautions Donald Rissmiller, chief researcher at Strategas Research Partners.
“Goldilocks is ending for the first time in 20 years,” he says, referring to the “just-right” era of low inflation and falling rates that propped up bonds until recently.
If you’re concerned about rising rates, stick with short-term bonds or funds for your core fixed-income allocation. Pimco Short-Term (PSHAX) has been a top performer, returning 1.9% this year. Its 30-day yield is 2.2%. Actively managed, strategic, or “total return” funds might sidestep market pressures if their managers act nimble enough. Pimco Strategic Bond (ATMAX) has returned 2.9% this year; it yields 1.8% and has a short duration: 1.1 years. Voya Strategic Income Opportunities (ISIAX) is up 2.2%. It yields 3.3% and has a 1.8-year duration.
What to do with your cash
One upside to rising rates is that money-market funds and other cash proxies pay a bit more — although not enough to generate a “real” inflation-adjusted return. Taxable money-market funds aimed at individuals yield an average 1.53%, up from 0.75% a year ago, according to Crane Data. Vanguard Prime Money Market (VMMXX) yields 2.2%. Mysavingsdirect, an online bank, offers a 2.25% annual percentage yield on savings of up to $2 million in deposits. Accounts held at American Express National Bank, Ally Bank, and Barclays Online Savings yield 1.9%.
Mortgage rates and home prices will be affected as well
Higher rates weigh on housing. They pressure home values, reduce affordability, and raise borrowing costs for mortgages and home-equity lines of credit. Home sales fell an average of 5% during the past six episodes of rising mortgage rates, going back to 1993, according to Freddie Mac. Prices might still increase if jobs and wages keep rising, supporting housing demand. But price gains will moderate, and borrowers won’t be able to afford as much. Fixed-rate 30-year mortgages, linked to the 30-year Treasury bond, now average 5.05%, up about a percentage point over the past year to the highest level since February 2011, according to the Mortgage Bankers Association. On a $400,000 loan, that adds $239 to monthly payments.
Adjustable-rate mortgages aren’t quite as costly, averaging 4.3% for those that adjust after five years. ARMs are pegged to the short-term fed-funds rate, which will likely keep rising into 2019, according to Fed forecasts. That could make today’s rates a better deal — although it’s anyone’s guess if that will be the case when the rate adjusts in 2023.