Tips for smart investing in a rising rate environment
Published 12:00 am Sunday, May 23, 2010
With short-term interest rates hovering near their historical lows — and with the Federal Reserve’s move earlier this year to raise the discount rate it charges banks to borrow from its coffers — it seems just a matter of time before the more important federal funds rate begins to rise. The question is when?
At its two-day, policy-making meeting in March, the Federal Reserve concluded that the still weak economy and subdued levels of inflation “are likely to warrant exceptionally low levels” for interest rates “for an extended period.” Many economists and market analysts expect the Fed to hold the federal funds rate stable until the unemployment rate declines more consistently — at some point in the third quarter or even after the November election.
Even so, investors will want to have their portfolios positioned for the time when interest rates eventually do begin an upward climb. Here are a few points that investors should keep in mind as they review and rethink their portfolio strategies with a new investment climate in mind.
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4 Bond prices will decline if rates tick up, because of the inverse relationship between interest rates and bond prices.Historically, rising interest rates have caused the prices of existing bonds to decline because newly issued bonds carry higher rates, which pushes down the value of previously issued securities. Bonds with longer-term maturities are most sensitive to rate changes.
4 Stock markets tend to react negatively to rising interest rates, which increase the cost of borrowing and impact corporate bottom lines. Financial stocks are especially sensitive to rising rates, since their funding base is tied to current market rates, although past performance is no indication of future results.
4 Fixed-income investors may want to consider dividend-paying stocks, which offer current income as well as the potential for longer-term price appreciation.
4 As short-term rates rise, rates on savings accounts and CDs will also rise, making them more attractive to investors.Rates on floating rate debt are also tied to short-term rates. The higher rates rise, the more sense it makes to pay down such debt whenever possible, especially higher-rate debt such as credit cards.
4 Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
4 CDs are FDIC insured and offer a fixed rate of return if held to maturity. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in the fund.
William McDonough is an investment representative associated with LPL Financial. Securities Offered Through LPL Financial * Member FINRA/SIPC.