Positioning Your Investments for Rising Rates

Positioning Your Investments for Rising Rates

What to Know

The Federal Reserve (Fed) has raised short-term interest rates three times since this rate hike cycle began in December 2015. With the long-awaited normalization of rates upon us, bond investors are grappling with the potential for significant interest rate risk for the first time since 2004. Here’s what to know and what to do about the changing fixed income environment.

Rates are normalizing, but still not normal

Although the Fed raised the federal funds rate three times since December 2015, it’s still historically low. Even if the Fed stays on pace with its planned increases, starting from near-zero will take time to reach the levels we saw a decade ago. Investors and markets are watching and waiting.

Today’s Rising Rates Are Still Extremely Low

Today's rising rates are still extremely low.
Federal Funds Target Rate. Source: U.S. Federal Reserve. Data as of 3/31/2017

The Fed is treading lightlyThe Fed's Considerations for Higher Rates or Maintaining Rates

The Fed wants to continue to normalize but also doesn’t want to further upset the economy and financial markets. Policy makers may be restricted by global geopolitical events and China’s slowing growth.

U.S. rates are much higher than the rest of the world—this also acts as a damper on higher long-term rates in the U.S. Add in the market pause due to uncertainty around President Trump’s policies, and the future of significant rate hikes looks less certain. 

Rates will likely rise

The pace and degree of Fed tightening calls typical rising rate solutions into question. In fact, we don’t believe markets are priced to reward investors looking to shorten duration or add yield to offset price declines. A higher fed funds rate doesn’t mean equally higher longer-term rates. We believe longer-term rates will remain contained going forward.

 Where to Look

Intermediate-Term BondsRich Taylor, Client Portfolio Manager, Fixed Income

We believe you should stay the course as rates continue to climb. If your time horizon is three years or greater, maintaining exposure to intermediate-term strategies can be beneficial. You’ll be reinvesting bond proceeds at higher rates, with the potential to create more income that can offset near-term price declines.

 

True or False: Bonds Always Lose Money When Rates Rise

True or False: Bonds Always Lose Money When Rates Rise
Hypothetical $10,000 investment in 5-year Treasury.
Source: Morningstar. Five-year Treasury represented by Ibbotson’s SBBI Intermediate -Term Government Index.

Higher Quality, not Higher Yield

Historically, bond investors have turned to higher-yielding spread products, such as high-yield corporate bonds, to help cushion the price declines associated with rising rates. However, yield spreads stand at historically tight levels, so investors may not receive the yield buffer that they are expecting.

Diversified Sources of Yield

In an environment marked by monetary tightening, rising rates, and rising inflation, a combination of diversified sources of yield has the potential to smooth out the income stream.

Diversification Isn’t Just for Total Returns

Diversification Isn't Just for Total Returns
Rolling 12-month yield.
Source: Bloomberg. Data as of 12/31/2016. Diversified Yield Sources combination line represented by 20% high-yield (Bloomberg Barclays U.S. Aggregate Credit – Corporate HY 2% Issuer Capped Index), 20% master limited partnerships (Alerian MLP Index), 20% International Value (MSCI EAFE Value Index), and 20% cash (Bloomberg Barclays 1-3 Month Treasury Bill).

 

For more information about investing options for rising rates, visit our websites or call us:

Diversification does not assure a profit nor does it protect against loss of principal.

Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.

The opinions expressed are those of Rich Taylor and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.