With recent moves by the Federal Reserve and headlines warning of rising interest rates to come, it’s been easy for investors to become skittish about fixed-income investing. After all, as interest rates rise, bond prices tend to decline, potentially reducing the value of fixed-income holdings. That may be true, but in this investment environment, there’s more to consider.
Given all the attention paid to rising interest rates, many people are surprised to learn that not all rates have necessarily moved up. Short-term interest rates have indeed risen this year, thanks to the Fed’s tightening moves. For longer-maturity bonds, however, market forces are what drive interest rates, not the Federal Reserve. As a result, rates for longer-term bonds – the ones most investors are concerned about – don’t always move up so quickly.
Although it can take a while for longer interest rates to catch up with their shorter counterparts, in time, rates across the maturity spectrum appear likely to move higher. It’s not too late to prepare for this possible shift in the market. But how?
Most fixed-income investors are seeking to keep risk fairly low, so it’s important to find ways to mitigate the risk associated with changing interest rates. One possible approach is to use a barbell strategy in a bond portfolio. This means investing in both very short-term and longer-maturity bonds.
The overall duration – or interest-rate sensitivity – of such a portfolio could be relatively moderate, as the potential volatility of the longer bonds would be offset by the relative stability of the short-term securities.
Overall, most investors will probably not want to make radical shifts in their bond portfolios in this time of interest-rate transition. However, a moderate change, perhaps including a barbell approach, may be helpful now and later as interest rates stabilize.
Many conservative investors believe that stocks don’t need to be part of their investment strategy, and after the volatility of recent years, it’s been easier to adopt that line of thinking.
Nonetheless, equities tend to perform well when longer-term interest rates are rising, and on the whole, stocks tend to perform well at different times than bonds. As a result, a modest equity weighting in a bond-oriented portfolio can offer an element of diversification. In fact, such a portfolio may offer less overall risk than a seemingly more conservative, all-bond portfolio. Again, investors don’t have to make radical shifts to benefit from such a strategy – a 20 percent stock position can be sufficient.
What about CDs? With the low short-term interest rates that have prevailed for so long, bank certificates of deposit (CDs) lost much of their allure, but now they are coming back. Clearly, there is a place for cash in most portfolios – and now that position is becoming a little more rewarding.
While CDs are certainly considered to be among the safest of all savings vehicles, there are still a few caveats. It’s natural to compare the rates of interest offered by competing CDs, but it’s also important to look beyond that single number and consider the overall quality of the institution that’s offering it. As with any other investment, it’s essential to read the fine print, looking out for teaser rates or other surprises, and to make sure you’re comfortable with the institution providing the CD.
While facing rising interest rates can be challenging, it’s important to remember that much of the difficulty comes in this time of transition – at the time when interest rates are making their move upward. As mentioned above, higher rates can have positive impact on equity returns. And over the longer term, higher rates can also be positive for bond investors. Simply put, higher rates equal greater levels of the income that is so vital to the total return of a fixed-income portfolio.
Daryl Waszak is a senior vice president at Marshall & Ilsley Trust Co., Milwaukee.
November 26, 2004, Small Business Times, Milwaukee, WI
