Interest Rates Rise: What’s next?
The Federal Reserve Board in December voted to raise the federal funds rate, a key short-term interest rate that impacts many other rates—marking only the 2nd time since 2006 it has done so. What’s more, the Fed hinted that more interest rate hikes were likely coming in 2017.
If you’re an investor who’s retired or about to retire, news of rising interest rates should cause you to take a close look at your investment portfolio. It may not be positioned to give you what you need in the year ahead.
The impact of the fed funds rate on a bond portfolio
For starters, it’s important to understand how rising rates might affect a portfolio. The relationship between bond prices and bond yields can be described like a teeter totter: as one goes up, the other goes down. So if yields rise, the value of a bond falls.
The Fed’s decisions about the federal funds rate can impact the yields that many types of bonds and other fixed-income securities pay to investors. While the federal funds rate isn’t the only determinant of a bond portfolio’s total return, a rising fed funds rate tends to put downward pressure on that return.
Consider Figure 1 below, which shows the average annual returns of the aggregate bond market and the S&P 500 during years when the federal funds target rate either went down, did not change, or went up. The key findings:
- When the fed funds rate fell, bonds tended to outperform stocks by 2% per year on average.
- But when that target rate rose, bonds tended to lag stocks significantly–by 6.8% per year, on average.
Figure 1: Average Annual Stock and Bond Returns Since 1991, Grouped by the Annual Change in the Federal Funds Target Rate
Source: Bloomberg L.P., as of December 23, 2016. Fed Target is the Federal Funds Target Rate – Upper Bound; AGG is the Barclays US AGG Total Return Value; SPX is the S&P 500 Total Return Index.
The upshot: If the federal funds target rate keeps rising in 2017, as many expect, fixed-income portfolios could suffer.
How different bonds react to rising rates
While the federal funds rate is arguably the most important interest rate on the planet, it isn’t the only driver of fixed-income returns. Various types of bonds can be impacted by many factors (for example, yields on longer term bonds can be affected significantly by expectations for future inflation and by global demand for yield).
As rates rise and fall, some bonds’ prices may be impacted strongly while others have a more muted response. One of the most common ways to measure a bond’s price sensitivity to changing interest rates is called duration. The price of a bond with a longer duration is more sensitive to changes in interest rates than is the price of a bond with a shorter duration.
A good middle-of-the-road proxy for measuring the impact of fluctuating rates across all maturities is the yield on the 10-year U.S. Treasury note. Figure 2 below shows the difference in the average annual return of five fixed-income asset classes during years when the 10-year Treasury yield rose, versus years when the 10-year Treasury yield fell.
Notice that all five categories posted negative returns during those years when the 10-year Treasury yield rose. Also notice that the average annual returns in most categories worsened as duration increased.
Figure 2: The Difference in Average Annual Returns for Years When the U.S. 10-Year Yield Rose, Minus Years When the US 10-Year Yield Fell (Since 1991)
Source: Bloomberg L.P., as of December 23, 2016. The US 10-year yield is the US Generic Govt 10 Year Yield; US Muni is the Bloomberg Barclays US Municipal Index; US AGG is the Barclays US AGG Index; US Corp is the Bloomberg Barclays US Corporate Index; US LT Treas is the Bloomberg Barclays US Long Treasury Index.
The takeaway: With the Fed signaling that rates are expected to continue to rise in 2017, total returns for fixed-income asset classes could come under extreme pressure—which could surprise many investors who have become used to the recent low rate environment under an accommodative Fed monetary policy.
For retirees and pre-retirees, that might spell trouble. Many retirement income solutions today rely on significant exposure to fixed-income securities as their core strategies—thus exposing their investors to increased levels of interest rate risk. Reducing fixed-income exposure and shifting portfolio allocations toward equities may help mitigate interest rate risks during those times when the Fed is raising rates and bond yields are on the rise.
Learn more about Real Spend®, our retirement income solution designed to mitigate interest rate risks.