For those in or near retirement who traditionally allocate a portion of their portfolio to fixed income: bonds, bond funds, money market accounts, certificates of deposit (CD), and fixed-rate annuities, the uncertainty cloud hanging over interest rates has been a big deal for the past several years. Generally, the Fed will hike interest rates several times after its initial increase. That wasn’t the case when last December they initially raised rates 25 basis points. Concerns over economic growth and global events caused the Fed to hold off with any additional increases. Now that the Fed is almost certain to raise rates at its upcoming December meeting and some are speculating that there may be subsequent rate increases, there are new implications for investors to consider.
The economy continues to improve and concerns are growing that further delaying rate hikes for too long could have negative repercussions on future economic growth. While the expected rate hike in the Fed Funds rate in December will likely only be 25 basis points, the size and frequency of any subsequent rate hikes is not easy to predict as the ever-changing economic landscape is what influences the Fed’s decisions.
Instead of trying to guess at what the Fed might do and when, investors can be proactive and examine their portfolio to understand the potential impacts of rising interest rates. This is particularly important for investors with a higher allocation of fixed income investments. Before we look at how rising rates can impact fixed income investments, let’s take a closer look at what could be driving their decisions.
The Fed’s monetary policy is driven by its goals of achieving maximum employment and stable prices by targeting 2% inflation rates. With the unemployment rate at 4.6% in November, the US labor market remains close to maximum employment and wage growth has also picked up recently. Core inflation, which excludes more volatile energy and food prices and tends to be a better indicator of future overall inflation, has been getting closer to the Fed’s target of 2%.
Economic growth also appears to be picking up steam. After rising at a rate of just 1% in the first half of the year, inflation-adjusted GDP in the third quarter increased 3.2% over last year. Following the election, many analysts revised future GDP growth estimates upwards as a result of some of President-elect Trump’s campaign focuses like deregulation and lowered corporate taxes.
Increased economic growth could push the labor market closer to maximum employment and the Fed’s 2% inflation target.
There has also been growing concern among the Fed’s Board of Governors, the decision makers behind the central bank’s interest rates, that keeping rates at current levels for too long could have broader negative implications for markets in the future.
According to comments Federal Reserve Board chair Janet Yellen made on November 17, the Fed believes the current economic growth will warrant only gradual increases in the federal funds rate to achieve its goals. Ongoing changes to the economic outlook and associated risks will guide its future decisions to increase rates.
Why Does It Matter for Fixed Income?
Fixed income investments, like bonds and brokered certificates of deposit, which are bank deposits that can be bought and resold, are often perceived as a low-risk investment. But different bonds can have different levels of risk—especially when interest rates start to rise. Duration risk arises from a bond’s sensitivity to changes in interest rates. When interest rates rise, bond prices fall, and vice versa. Typically, the higher a bond’s duration, the more sensitive it is to interest rate changes. While this isn’t a big problem for investors that can hold the bonds to maturity, investors that decide to sell or need the principal before maturity could be forced to accept a lower price when trying to sell their bonds if interest rates have risen.
Ultimately, nobody can predict when and how much the Fed will raise interest rates. However, regardless of the Fed’s decisions, it’s probably a good time to take a closer look at your portfolio and examine your risk exposure.
To protect against duration risk, investors could benefit from shifting away from long-term bonds to shorter-term bonds, which typically experience less price volatility. It could also be worthwhile examining portfolio strategies like bond and CD laddering, where investors purchase several bonds or CDs with staggered maturity dates. This can help minimize some of the associated risks with these types of investments and ensure a steady stream of cash flows.
Just because there’s a lot of uncertainty surrounding rising interest rates in the future doesn’t mean you should abandon fixed income altogether. A move like that can be especially risky for retirees who want a variety of potential income streams. Instead, take a closer look at your portfolio and slowly adjust your investments to a level of risk you’re comfortable with.
If you don’t have time to actively manage your portfolio, but want to stay in the market, check out Essential Portfolios, a new robo-advisor offering automated portfolio recommendations that are based on your goals and investing profile.
Looking for more retirement information and resources? Visit the Retirement Planning page.