How might rate increases impact long-term investing decisions? What’s the impact of a rate hike on long-term savings?
That’s understandable if you’re a long-term investor with positions in fixed income. The benchmark U.S. 10-year Treasury yield touched decade highs above 3% in late 2018, then quickly plunged to historic lows down near 1.4% by mid-2019 as the Fed reversed its policy and the narrative went from rate hikes to rate cuts.
This rapid turnaround might have your head spinning as a long-term investor, wondering how to position your portfolio for a lower-rate environment. Lower rates mean investors might want to consider slight modifications in their fixed income and equity strategies with a focus on time horizons. Think of it as an adjustment, not a wholesale revamp like the Fed’s.
That said, because interest rates are so fickle, it’s good to be cautious about making changes based on a few months of lower bond yields or Fed rate cuts. Rates go up and down, but that doesn’t necessarily mean you have to jump every time the Fed snaps its fingers.
“Longer-term investors often prefer to stick to their discipline and stay the course,” said Robert Siuty, senior financial consultant at TD Ameritrade. “That means having a well-diversified portfolio across asset classes and an appropriate mix based on their risk profile. They should also monitor and rebalance as appropriate.”
When rates start falling, as they did in 2019, investors with fixed income in their portfolios sometimes panic. However, low interest rates don’t necessarily make fixed income a lesser investment.
“Fixed income always has a place in the portfolio, especially for folks approaching retirement,” Siuty said. “It still pays yield and can sometimes help buffer volatility.”
That said, low rates can affect how investors might want to approach the fixed income market. Suddenly, longer-duration fixed income products can start to look a little less compelling. The so-called “short end” of the yield curve, meaning bonds with durations on the closer side of the time spectrum, might get a little more love.
Why? Consider this. If you buy a 30-year bond at the late-2019 rate of approximately 3%, and then the bond market takes a dive and rates go back up, you might have trouble selling the bond into a market where new 30-year bonds pay 5%.
“No one will pay you what you paid for it, and you’ll have to sell at a discount,” Siuty noted.
Instead, some investors in times of volatile rates choose to build a “bond ladder,” with their portfolio holding bonds of various time durations to help balance the risk from rising rates.
TD Ameritrade can help you find investments to mitigate market volatility.
“A ladder approach makes sense when you blend maturities,” Siuty said. “Say you buy a one-year, a two-year, a four-year, and a five-year. You stagger out the maturities, and each year when one expires, you get a pile of money back and can reinvest in fixed income or elsewhere. That way, you keep your options open” if the rate picture changes over the course of time.
Let’s look at short-duration bonds versus long-duration bonds to better understand how a ladder might work in a falling-rate environment:
Short-maturity bonds tend to have low coupon payments, but may provide more price stability than long-term bonds.
Long-maturity bonds tend to have relatively higher coupon payments, but also often come with greater price fluctuations than bonds with short maturities.
A diversified bond ladder can balance the timing of payments and fluctuations in prices caused by changing interest rates. In short, holding some long-term bonds might give a portfolio higher returns, while short-term bonds can provide some stability.
The beauty of a bond ladder is that it can work in both a rising- and falling-rate environment. In a rising-rate environment, when the one-year bond on the ladder matures, an investor can buy a five-year bond to replace it and keep the ladder going.
It’s the opposite in a falling-rate situation. If that’s the case, then you might consider reinvesting on the shorter end. You can always adjust your ladder as things mature.
Even if you don’t want to put a bond ladder together, low rates often have investors gravitating toward the short end of the duration mix.
“Sticking to the short-term or intermediate term might make sense in a low-rate environment because of the price sensitivity of the longer end,” Siuty said. “The longer-duration bonds tend to fall the most when rates rise.”
There’s risk associated with bonds, even when you diversify by building a ladder. Government bonds tend to be less risky than corporate bonds, and usually have a lower interest rate. But there can be different rates even among corporate bonds. This is because of something known as default risk, which happens when an issuer goes out of business and isn’t able to pay back the principal—or make any remaining interest payments—on the bonds they’ve issued.
There’s generally a lower risk of default for municipal bonds, but investors should understand and be comfortable with the issuer of the bond. If you're interested in a quick refresher, refer to this bonds and fixed-income investments primer.
Some of the risks in buying bonds may be mitigated by buying only those that are highly rated. Various agencies such as Moody’s and Standard & Poor’s issue, track, and update bond ratings on a regular basis, but they each have their own grading criteria, so investors need to educate themselves.
All that said, a carefully considered shift in your fixed income positioning can potentially help you navigate a falling rate environment as long as you’re aware of the risks. So if a rate plunge has you feeling dizzy, you might want to grab a ladder and climb on.
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