How will rising interest rates affect your investments?

Interest Rates and Bond Prices

Markets are highly complex and interest rates do not always affect investments the way pundits speculate they will. However, with bond prices, the effect of interest rate changes is in fact both direct and mathematically calculable.To get a bond’s current yield, divide the interest it pays by its current price. If the price goes up, the yield goes down. If the price goes down, the yield goes up. Thus, in order for the yield to go up the price must go down. When you read that rates on bonds have risen, it means their prices have fallen.

Higher yields mean higher risk, no exceptions. Anything paying high interest should be considered suspect, not enticing.

In the spring of 2013, when interest rates did finally rise a little, we felt compelled to write “Interest Rates Up, Bonds Down. Now What?” about which bonds were exposed to greater risk and how we manage the risks. We did not believe the potential for rates to rise was a cause for concern because we favor shorter term bonds which are less susceptible to interest rate changes. Long term bonds are much riskier, we explained.

As 2013 came to a close, the Federal Reserve had not raised the target rates it controls, yet yields on longer term issues rose anyway. The 30-year treasury was yielding 3.98%, up from a low of 2.81% in May. Figure A  illustrates our point. It contrasts the changes in the market value of an exchange traded fund that holds only U.S. treasury securities with maturities of three years or less (green line) with the changes in the market value of an exchange traded fund that holds only U.S. treasury securities with maturities of 20 years or more (orange line) from May 1 to December 31, 2013.

Short term bonds are far less risky than long term bonds.

Short term bonds are far less risky than long term bonds.

Given that the primary reason to hold bonds is for stability, it is easy to see why we favor shorter maturities. We may not get a high rate of interest from shorter term holdings but we will protect assets from significant losses – a classic risk/reward trade off. The difference in volatility is striking. An 18% decline in value in just a few months is what we would expect periodically from the stock market. Such large losses are avoidable as long as we do not seek substantially higher yields than is available in the market.

Higher yields mean higher risk, no exceptions. Anything paying high interest should be considered suspect, not enticing.

Interest Rates and Stock Prices

While the relationship between interest rates and bonds is clear, direct, and predictable, the connection between interest rates and stock prices is decidedly unreliable.

Theoretically, if interest rates go up, stock prices would go down. Corporations would have higher costs to borrow which would cut into profits. With bonds yielding more, some people would be motivated to move money from stocks to bonds and would accept lower prices to make the switch. That’s the theory. The reality? No one knows what will happen but the historic record simply does not support the theory. As we are quick to point out, markets are unpredictable because there are so many other variables which come into play.

We have seen a steady stream of studies looking at stock market performance during prior periods of rising rates and the conclusion is interest rates do not affect stock performance as neatly as the theories suggest. For instance, a UBS study looked at the last six times the Fed raised the federal funds rate after two good years for stocks. Only in 1994 did stocks (as represented by the S&P 500 index) retreat when they declined 1.5% from the time the Fed started to raise rates in February through the end of that year. In the other five instances, the weakest advance was 11.3% over nine months in 1999 and the strongest came after rate increases in 1988 that logged a 41.9% advance over 28 months.

stocksA longer term analysis comes from Dr. Craig Israelson of Brigham Young University. He looked at the 34-year period of 1948-1981 in which market interest rates generally rose. For instance, the Fed’s discount rate climbed from 1.34% to 13.42% during that period. Israelson then examined the following 31 years in which rates generally fell, ending in 2012 with the Fed discount rate at .75%. The years 34 and 31 compare favorably to the length of a productive working career or a full retirement. The average annual return for the S&P 500 in the period of rising rates was 11%. During the falling rate period it was 11.14%. (Financial Planning, March 2013)

Also of note was that his study supports our contention that broad diversification is the best approach to navigating chaotic and volatile markets. The difference in the performance of the bond indexes in the rising rate period versus the falling rate period was significant, 3.83% vs. 8.82%. However, by diversifying, the effect of the rate changes was reduced. A simple switch to an annually rebalanced mix of 60% stocks and 40% bonds raised the returns. This makes sense since we would expect stocks to beat bonds over long periods of time. The difference between the 60/40 mix in the rising rate period and the 60/40 mix in the falling rate period was less dramatic than the all bond scenarios, 8.52% vs. 10.56%. When Israelson replaced some of the large company stocks with small company stocks and used cash in place of some bonds, the difference in results shrunk even more, 9.52% vs. 9.99%.

Israelson then provided an example of how powerful diversification can be as a way of managing risk. He starts with a diversified 12 asset class portfolio annually rebalanced over the 10 year period 2003-2012. He then replaces the actual bond returns in that period with the returns from the worst 10 years for bonds (1950-1959, 1.34%). This lowered the annualized return of the diversified portfolio by a mere .35% per year compared to the actual results.
These are averages. In none of these time frames did things go smoothly in the markets, economically or politically. The tax code and inflation rate changed often. We diversify precisely because the world is full of uncertainties.

As Israelson put it, “By design, a diversified investment portfolio is insulated – not completely, but largely – from the normal swings in performance among its various components. The underperformance of one or several of its ingredients will not sink the performance of the overall portfolio. In fact, a strategically built, diversified portfolio will always include asset classes that have underperformed within a time frame. This is unavoidable. But it’s the overall performance of the entire portfolio that matters. We can’t predict with accuracy the future returns of various asset classes, but based on the past it is clear that building diversified portfolios liberates us from needing to make such predictions.”

Contact Us

If you have any questions or would like to discuss this further, please give us a call or send us a note.

To receive emails notifying you of new posts – no more than monthly – fill out the subscription information in the sidebar to the right.

 

 Contact Us


Moisand Fitzgerald Tamayo, LLC is an Orlando, Tampa and Melbourne, Florida based fee-only financial planner serving central Florida and clients across the country. Moisand Fitzgerald Tamayo, LLC specializes in providing objective financial planning, retirement planning, and investment management to help clients build, manage, grow, and protect their assets through all phases of one’s life and the many transitions in between. If you have any questions or would like to discuss anything further, please give us a call or send us a note. If you are not a client and wish to receive emails notifying you of new posts – no more than once per month – fill out the subscription information in the sidebar to the right. For more frequent updates, follow us on FacebookLinkedIn, or Twitter.  

Important Additional Information & Disclosures


Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Moisand Fitzgerald Tamayo, LLC-“MFT”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. 

Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from MFT. 

Please remember that if you are a MFT client, it remains your responsibility to advise MFT, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. MFT is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. Tax advice is given only to clients and only when agreed to by MFT. A copy of the MFT’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request.

Please Note: MFT does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to MFT’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

Please Note: Limitations:  While MFT does NOT pay for recognition, awards, or publicity, neither rankings and/or recognition by unaffiliated rating services, publications, or other organizations, nor the achievement of any designation or certification, should be construed by a client or prospective client as a guarantee that he/she will experience a certain level of results if MFT is engaged, or continues to be engaged, to provide investment advisory services. Rankings published by magazines, and others, generally base their selections exclusively on information prepared and/or submitted by the recognized adviser. Rankings are generally limited to participating advisers. No ranking or recognition should be construed as a current or past endorsement of MFT by any of its clients.  ANY QUESTIONS: MFT’s Chief Compliance Officer remains available to address any questions regarding rankings and/or recognitions, including providing the criteria used for any reflected ranking.

Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results.  It should not be assumed that your MFT account holdings correspond directly to any comparative indices or categories. Please Also Note: (1) performance results do not reflect the impact of taxes; (2) comparative benchmarks/indices may be more or less volatile than your MFT accounts; and, (3) a description of each comparative benchmark/index is available upon request.

 

About Dan Moisand

Dan Moisand is a fee-only financial advisor with Moisand Fitzgerald Tamayo, LLC. He is a regular contributor for multiple outlets, including Florida Today, MarketWatch, and The Wall Street Journal. His writing and financial advice have also been featured in Financial Planning, Investment Advisor, Wealth Manager/Advising Boomers, Forbes, Smart Money, and The New York Times, among other publications. He is the only two-time winner of the Journal of Financial Planning’s “Call for Papers” competition and has been named a top financial planner and advisor by multiple publications. Investment News named Dan one of the “twenty most influential men and women” in the history of financial planning. He currently serves on the Board of Directors for the CFP (Certified Financial Planner) Board.

WANT TO KNOW WHEN WE POST NEW MATERIAL?

As a Sanctuary From The Noise®, we only post information we believe timely and important to the long term financial success of our clients. Follow us to receive emails - no more than once a month - about new posts.

We keep your information private and make stopping our emails as easy as starting them.

Something went wrong. Please check your entries and try again.