Uncertainty surrounding low interest rates and their future direction has been a cause for concern among investors nearing, or in, retirement for quite some time. Low interest rates have impacted portfolios that traditionally have a higher allocation towards fixed-income investments like bonds, bond funds, money market accounts, certificates of deposit (CD), and fixed-rate annuities. Another challenge is a lot of people might’ve made plans for generating income in retirement when yields were much higher, but they’ve remained close to historic lows for much longer than expected.
Now it’s starting to look like the rate hike cycle might accelerate a little faster than originally anticipated. Towards the end of February, CME futures predicted about a 35% chance of a rate hike in March. By March 3rd, the CME futures had jumped to approximately an 80% chance. Federal Reserve Chair Janet Yellen indicated in a recent speech that if employment and inflation are in line with the committee’s expectations, an increase of the Fed funds rate would likely be appropriate. President Trump’s well-received Congressional address as well as remarks from several Fed Governors were key reasons for the quick jump in the chance of a rate hike in March. If the Fed hikes in March, it’ll be only the third time in about a decade.
The Fed has also been keeping a close eye on global economic developments to determine its monetary policy. The Eurozone recently reported inflation higher than expected and above the European Central Bank’s (ECB) target of “below but close to” 2%. The Eurozone is still experiencing a weak recovery, but this could be a sign of greater improvement.
Anytime the markets are undergoing major changes like this, it’s a good idea to be proactive and examine your portfolio to understand the potential impacts of rising interest rates. If you have a higher allocation towards fixed income investments, it’s particularly important for you to examine your risk exposure in a rising rate environment.
Why Does It Matter for Fixed Income?
Fixed income investments, like bonds and brokered CDs–certificates of deposits that can be bought and resold—are frequently perceived to be a low-risk investment. But there are still risks to consider with fixed income investments, especially as interest rates 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 will be to interest rate changes. This might not be an issue for investors that plan to hold the bonds to maturity, but it can still be a good idea to plan for the unexpected or be more conservative if you might need the cash. Investors that decide to sell before maturity might have to sell at a lower price than they anticipated depending on how much interest rates have risen. Some bonds, like high-yield (“junk”) bonds and emerging-markets debt, have become more popular in the hunt for higher yields, but they can sometimes be harder to sell prior to maturity due to limited liquidity.
Time to Examine Your Portfolio?
Investors looking to minimize duration risk could benefit from shifting away from long-term bonds to shorter-term bonds, which typically experience less price volatility. Portfolio strategies like bond and CD laddering, where investors purchase several bonds or CDs with staggered maturity dates, are another strategy to consider. Bond and CD ladders may help minimize some of the associated risks with these types of investments and provide a regular 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.
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Editor's Note: This article is an update of the original Retirees and Fixed Income: Rethinking Interest Rates—Again published on December 6, 2016.