The last time the Federal Reserve raised interest rates was in 2006. Following recent signals from the Fed, the prospect of higher interest rates and sustained market volatility as it starts to change direction from its historic policy of Quantitative Easing (QE) should raise a caution flag for investors who want to protect their portfolios. Recognizing this is the easy part.
The tough part is having to come up with a plan to protect your portfolio, which can be sensitive to fluctuating rates depending on the types of investments it includes. Once you understand which types can better weather fluctuating rates, you can start to form a plan and then execute it. It can be difficult, however, which is why this is where the majority of investors lose sight of what they are doing. Since the best offense is a good defense, here’s how to defend your portfolio against the ravages of a rising interest rate environment.
The characteristics of defensive stocks are that they have low price-earnings (P/E) ratios compared to cyclical stocks throughout a business cycle. These stocks also have a low beta, or relative risk and performance to the market, which means they tend to perform better relative to cyclical stocks in bad times. In a boom part of the business cycle, defensive stocks are not as attractive to investors since defensive stocks rarely tend to see high rates of organic growth.
For portfolio relief in times of rising rates, investors have traditionally headed for defensive positions in stocks that are part of life’s basics: utilities, oil, real estate, food, beverage, tobacco, consumer staples and pharmaceuticals. These stocks are in non-cyclical stock sectors, and often do not do as well in an appreciating market. They can, however, deliver better protection in a rising rate environment. Banks also work well in a rising rate environment, as they can increase profits lending at higher rates.
Water, gas and electric utilities are also deemed defensive stocks since they focus on housing requirements. Real estate investment trusts (REITs), which are trusts that purchase real estate to generate returns from rent or appreciation, are also appealing, especially if the REIT invests in moderate income housing, as opposed to high-end rentals.
Finally, another favored traditional sector has been gold. But aside from its use in jewelry, gold as an investment is out of favor. That’s because there is so much gold available from Russia, China and Taiwan that prices have suffered.
But which sectors get hurt in a rising rate environment? Housing is the main victim. Given the slowly recovering housing market, a rate rise will force more people out of purchasing and into rentals. Home improvement stores should also be weaker performers. For instance, the exchange-traded fund (ETF) tracking real estate companies (ticker symbol IYR) has fallen 8.7% from February through June as rates have inched higher. During about this same period, the yield on the benchmark U.S. 10-year note—a good gauge of the direction of mortgage rates—has gone from 1.6% to 2.3% as of June 13.
For the fixed income part of your portfolio, bonds should also be considered if you want protection. The easiest and safest way to play rising rates is through a laddered bond portfolio. This is a portfolio where your bond maturities are “laddered,” or staggered to give you a constant return over a given period, for instance, one to five years.
This strategy gives you exposure to different points in the yield curve. Also, as rates increase or decrease over the duration of your bond exposure, you get some price protection if rates become volatile.
There are a few ways to build a laddered bond position. One is in the cash market. Bonds are purchased in increments of $10,000. But if that is too pricey, consider a bond mutual fund, which often mixes different grades of corporate bonds and maturities. For more prudent investors, move to a government or a municipal bond (muni-bond) fund. Relatively speaking, muni-bonds carry less risk than corporate bonds, and will protect your principal (original investment amount). Because of this, however, you will only earn the prevailing interest rate. Corporate bonds carry higher risk at the expense of greater principal exposure.
A third way is through exchange-traded funds (ETFs). Various managers offer laddered bond ETFs that include a large portfolio of corporate and high yield bonds. The benefit is that the laddered bond positions are in a single EFT, so they are easy to purchase and monitor. Holding a larger portfolio of bonds that are contained in an ETF is beneficial since it spreads the rate risk. This is more easily done in mutual funds or ETFs as opposed to holding individual bonds.
The Impact of Inflation
It is important to note that there is no immediate connection between rising rates and inflation. The two are related, but inflation, which carries a distinct set of other serious problems, develops over a much slower time frame. Still, if you are worried about market gyrations as a result of rising interest rates, then that stomach acid feeling may be nature’s way of saying it is time for a change.
That’s not to say that inflation is benign. The cascading effects of high inflation erode living standards and cause artificially high corporate profits and rising interest rates. Higher rates contributed to the savings and loan crisis of the early 1980s, which cost taxpayers about $160 billion in payments for federal deposit insurance.
At about the same time, high inflation and loose lending policies wreaked havoc on American farmers who borrowed heavily against the run-up in commodity and farmland prices. When rates rose and commodity prices declined in the 1980s, farm foreclosures skyrocketed. There are other similar sad stories that link inflation to the Third World debt crisis in the early 1980s, and public sentiment against investing in the stock market.
It has been almost 50 years since the U.S. economy saw the start of an economic cycle dominated by inflation. Starting in 1960 and ending in 1979, U.S. inflation went from 1.4% to 13.3%. By 2001, it was almost back to where it was in 1960, 1.6%. During this period, inflation not only affected prices, but it had a huge impact on politics, business, employer-employee relations, global trade and how American society evolved.
Today, investors should take note of the stronger dollar and its impact on international companies, which could be hurt by the strong dollar. While many people today do not recall this period, which is known as the Great Inflation, and lasted from about the mid-1960s to the early 1980s, it could be considered the greatest domestic policy mistake since World War II.
While the Fed’s move away from QE may be coming to a close soon, any interest rate increases from these historic lows should not produce the ill-effects seen in the Great Inflation. But investors should still note that few economies have gone as long as a decade without falling into a recession. When that happens, inflation again becomes a concern. That’s the economic reality, so all investors should plan accordingly.
For more investment advice from Chuck Epstein, read his article on the keys to retirement success.