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When Rates Rise, Doing Nothing Can Cost You

by Community Manager

‎11-13-2013 03:27 PM

marqueeBanner_mc_with-ribbon_industry insights.jpgIn late 2008, with the United States mired in its worst financial downturn since the Great Depression, the Federal Reserve cut interest rates to their lowest level ever and promised to keep them there for as long as necessary to help get the economy back on its feet.

 

With a healthier housing market, solid corporate profits and lower unemployment, we believe the economy is getting stronger. As a result, the time for the Fed to start raising interest rates is getting closer.

 

There is no set timetable for action, but we believe it's likely that long-term interest rates in the U.S. will climb gradually over the next two to three years. The Fed has been hesitant to start raising rates, which suggests that it would rather wait too long than to act too soon and jeopardize the economic progress made over the past four years. In fact, it is possible that interest rates could remain at current lows for quite some time, given persistently slow GDP growth as consumers continue to pay down debt.

 

Favorable for Stocks?

 

Gradually rising interest rates have generally presented a favorable scenario for stocks, which we believe will generate higher returns than bonds over the next three to five years. While the stock market has clearly benefited from the prolonged period of low rates, we think a tempered rise in rates would indicate that the U.S. economy is expected to grow faster in a low-inflation environment. This combination tends to result in earnings and dividend growth, and higher stock prices and price-to-earnings ratios. Volatility, however, may increase because markets often overreact in the short term during periods of transition.

 

In our view, gradually rising rates generally make a neutral case for bonds. As rates move higher, the prices of existing bonds fall, mainly because investors will prefer to own newly issued bonds that make higher interest payments. Bonds with a shorter time to maturity can be attractive when rates are rising. When these bonds mature, investors can take advantage of rising rates by investing their returned principal in new bonds with higher interest payments.

 

How individual investors should react to the prospect of rising interest rates is not a one-size-fits-all proposition, given differences in risk tolerance, investment time horizon and other factors.

 

A Possible Bond Risk

 

We are concerned, however, that many of our members who sought to protect their wealth during the financial crisis may still be holding too much of their portfolios in bonds and cash. This imbalance may expose them to excessive bond risk as we approach a period of rising interest rates.

 

Members with well-diversified portfolios also may want to better position themselves for rising interest rates. Such adjustments could include modest allocation shifts between stocks and bonds, as well as moves to diversify bond holdings. One example could involve shifting part of a position in Treasuries to investment-grade corporate bonds. The additional yield provided by corporate bonds can help cushion against the impact of rising rates. A couple of examples — one focusing on a member still saving for retirement and the other of a member already in retirement — may help illustrate some subtle adjustments that could affect portfolio risk and return in a rising interest-rate environment.

 

Assumptions: The hypothetical scenarios below cover a five-year period in which we assume rates go up half a percentage point every six months for the first 18 months (1.5 percentage points total) and then remain constant. An explanation of portfolio returns and other assumptions in the scenarios are addressed in the disclosures at the end of this commentary.1

 

Member Scenario 1:

 

50 years old, $500,000 portfolio, $10,000 annual contribution, plans to retire at 65

 

Thirty percent of the member's starting portfolio of $500,000 is allocated to stocks, 55% percent to bonds and 15% to cash. The member still is building pre-retirement wealth, so to help the account grow, he will contribute $10,000 at the beginning of each year.

 

The hypothetical annual return for this conservative portfolio is 3.19%. Shifting a portion of the medium-term corporate bond allocation to stocks (Column 1) provides significantly greater return through price appreciation and dividends, which compensates the member for added risk of stock market volatility. Adding short-term corporate bonds while reducing Treasuries in the portfolio (Column 2) further raises the portfolio's return. There, the trade-off is assuming some risk of default by the bond issuers. Shortening the maturity range for the remaining Treasuries in the portfolio (Column 3) has little impact on return, but it reduces exposure to rising interest rates. Finally, moving most of the cash held in a one-year certificate of deposit (Column 4) into short-term Treasuries provides more return, thus reducing the erosion of purchasing power caused by inflation.

 



Assuming that all four of these portfolio adjustments are made at the beginning of the five-year period, the annualized return for this portfolio climbs to 3.90% and exposure to interest-rate risk is reduced. In dollar terms, the $500,000 portfolio would grow to roughly $660,000 in five years, compared with $639,000 if the original allocation was maintained. The difference between 3.19% and 3.90% in annual returns may not seem like much, but over five years, it represents more than $21,000 in additional wealth.

 

Member Scenario 2:

 

70-year-old retiree, $1 million portfolio, $50,000 annual withdrawal for income

 

The retired member starts with a larger but more conservative portfolio than the member still working — a 20% allocation to stocks, 60% in bonds (mostly Treasuries) and 20% in cash. The retired member is no longer making contributions and also needs to withdraw $50,000 each year to cover living expenses, so preserving wealth in the account is a priority.

 

As in the first scenario, a move from medium-term corporate bonds to stocks provides the largest impact on returns (Column 1). In this case, however, the allocation shift is smaller (5%, compared with 10% in Scenario 1) and thus the additional return is smaller. This limits the retired member's exposure to stock-market risk. Cutting back cash to buy short-term Treasuries (Column 4) also boosts return, and at the same time reduces inflation risk.

 

The ending portfolio actually increases the overall allocation to bonds to 65% of the portfolio. This may not seem to make sense when interest rates are rising, given the inverse relationship between rates and bond prices discussed earlier. But shifting the bond allocation toward shorter maturities, both for corporate and Treasuries (Columns 2 and 3), adds return while limiting interest-rate risk.

 



 

Based on our assumptions, the starting portfolio has an annual return of 2.46%. Making the portfolio moves above at the beginning of the five-year period lifts the annual return to 2.90%, which adds up to about $22,500 more for the member than if he did nothing.

 

One of the most important investment decisions that USAA members will face in the years ahead is the allocation they make between stocks and bonds in their portfolios.

 

For the past 30 years, we have seen a bull market for bonds that has generated returns that would be mathematically impossible to replicate over the next three decades. That said, for investors, the choice to make as interest rates rise is not as simple as either owning bonds or not owning bonds. We believe that, rather than a bond market, there exists a market of bonds offering a breadth of risk and return characteristics that may appeal to a range of investors, depending on their investment objectives.

 

Rising interest rates can affect the performance of the various asset classes, but they are only one such factor among many that influence returns. It is important to stress that members should not veer away from their long-term investment objectives out of fear of short-term market impacts. USAA's team of financial advisors can assist members with the structuring of their portfolios based on their unique situation.



This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.



These hypothetical illustrations were prepared and compiled by USAA Financial Advisors Inc. (FAI), a registered broker-dealer. The information contained herein is intended for the sole and exclusive use of FAI customers or other authorized users. The material has been prepared and is distributed solely for informational purposes and is not a solicitation, recommendation or an offer to buy or sell any security or instrument or to participate in any trading or advisory strategy. Some of the information contained in this material was obtained from outside sources believed to be reliable but is not guaranteed to be accurate and is subject to change without notice.

1 Illustrations are based upon hypothetical calculations and certain assumptions (explained below) and do not reflect actual performance. Different assumptions would produce different results; assumptions are current as of the date of publication. Asset classes shown are based upon market indexes. Illustration does not account for transaction costs, taxes or associated investment fees. Withdrawals from tax-advantaged accounts may result in taxes and/or penalties. Consult your tax advisor on your specific situation.

2 Starting, ending and interim portfolios are hypothetical and do not represent any particular brand or type of modeled portfolio. Individual investor risk tolerances may vary from the hypothetical portfolio allocations.3 Stock returns of 7.02% are based upon the geometric return of the S&P 500 Total Return Index over the last 10 years (2003-2012).

4 Bond impacts are modeled within the Barclays' Point® software package using the assumptions below. Different assumptions would produce different results.

  • Interest rates: We are assuming interest rates rise by 50 basis points every six months for 18 months for a total interest rate increase of 1.5%. From months 18-60, interest rates remain flat. We believe this to be a reasonable pattern of interest rate movement based upon data published by the Federal Reserve related to the magnitude and frequency of interest rate increases occurring between 1980 and 2008; interest rate environments have remained static from 2008 through the date of publication.
  • Yield curve: To simplify our example, we are assuming that interest rates rise evenly across the yield curve. For example, a 1% rise in rates will impact both a one-year and a 20-year bond by 1%.
  • Bond spreads: To simplify our example, we are assuming the spread remains constant. The difference in yield between corporate/municipal bonds and treasury bonds is often referred to as the "spread."
  • Re-investment: We are assuming for all bonds, income and principal distribution are reinvested at current market interest rates. The Barclay's Point® software package knows when a bond within the indices we are using in this model will mature. If a bond matures within the timeframe of our illustration, the portfolio will "roll into" a similar bond but with the higher market interest rate. For example, if one of the indexes has a three-year bond yielding 2% that will mature next year, then at that point in time, our model hypothetically re-invests in another three-year bond. This new bond, however, will yield 3% instead of 2% because rates will have risen by 1%.

 

Data sources for bond indexes are as follows:

  • For Corporate Investment Grade (7-10 year): Barclay's 7-10 Year Corporate Index
  • For Corporate Investment Grade (3-5 year): Barclay's 3-5 Year Corporate Aggregate Index
  • For Treasuries (3-5 year) : Barclay's 3-5 Year Treasury Index
  • For Treasuries (1-3 year): Barclay's 1-3 Year Treasury Index

5 Certificate of deposit rates are assumed to remain flat. Data source for one-year fixed rate CD: Federal Reserve Bank of St. Louis National Rate of one-year fixed rate CDs (bank and thrifts)

 

Originally posted on Nov. 7, 2013

 

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