Investors haven't had to deal with rising interest rates like this since the Rubik's Cube and Post-it Notes were novel in the 1980s. But rates are soaring now, forcing generations of puzzled investors who've never seen rates rise to rip up their outdated playbooks.
Talk about turning investors' plans upside down. Money has been practically free to borrow for years. But we've gone from "lower for longer" to "higher for longer" fast.
The yield on the 10-year Treasury is pushing 5%, trading around its highest in 16 years. That's up from just 0.52% in August of 2020. And back then, rates were falling from greater heights — not rising fast from longtime low levels like they are now.
Rising interest rates might seem like an interesting sideshow to the stock market. But no one dares to fight the Fed for a reason. Suddenly, lowly savings accounts paying 5% or more challenge the motivation to buy stocks. Investing in a rising interest rate environment calls for a whole different approach.
The biggest challenge? Bonds, which usually offer a safety net, won't paper over stock drops when rates are rising. As interest rates increase, the prices of existing bonds drop.
Rising Interest Rates Challenge Stocks
Meanwhile, stocks, typically the growth engines of investors' portfolios, become less appealing. Suddenly, companies' profits can take a hit as they either pay more to borrow or borrow less. That leaves them with less money to grow their business. And relative to bonds, stocks can seem less attractive.
"Rising interest rate environments are often challenging for stocks," said Bob Johnson, the CEO of Economic Index Associates and a professor at Creighton University. "Berkshire Hathaway Chairman Warren Buffett has said that 'interest rates act on financial valuations the way gravity acts on matter. The higher the rate, the greater the downward pull. That's because rates of return that investors need from any kind of investment are directly tied to the rate they can earn from government securities.'"
Consider: The S&P 500 dividend yield was 1.63% as of Oct. 23, while the 10-year Treasury bond yield was 4.91%. This means that the 10-year Treasury bond yield is 3.28 percentage points higher than the S&P 500 dividend yield.
That's one of the widest spreads between the two yields since 2007. And that's not good news for stocks.
Rising Interest Rates Restrain Expansion
And then there's the economy. Rising rates are equivalent to the Fed stamping on the economy's brake pedal. A rise in interest rates can dampen economic expansion — though that doesn't seem to be the case just yet.
"In the current rate and market environment, we are dealing with rising interest rates and a still growing economy," said Scott Bishop, a partner with Presidio Wealth Partners in Houston. He noted that the Federal Reserve Bank of Atlanta is estimating GDP grew 4.9% in the third quarter and that could lead to additional market volatility.
Those headwinds notwithstanding, investors have several ways to protect their portfolios and potentially generate returns.
Higher Interest Rates Make Some Assets More Attractive
"With so much uncertainty in the economic outlook, it becomes all the more important to recognize and manage the risks inherent in the current environment, perhaps by shifting more assets into shorter-term, less-volatile assets like short-term Treasury bills or even cash" (which, thanks to higher interest rates, are yielding significantly more than they did up until recently), wrote Larry Swedroe, the head of financial and economic research at Buckingham Strategic Wealth on Kitces.com.
Others share that point of view. Bishop recommends avoiding credit risk by holding shorter-term U.S. Treasury bills or higher yielding money market funds that have underlying assets of government securities. Fidelity's Government Money Market Fund had a seven-day yield of 4.98% as of Oct. 17.
Credit risk refers to the risk that a bond issuer will default on its debt obligations by failing to repay interest or principal in a timely manner. All bonds carry some degree of credit risk.
Invest In Treasury Bills Directly
U.S. Treasury bills, also known as T-bills, are short-term government securities issued by the U.S. Department of the Treasury. They are regarded as one of the safest investments in the world because they are backed by the full faith and credit of the U.S. government. The 3-month U.S. Treasury bill yield on Oct. 23 was 5.46%, the highest since 2007.
Swedroe recommends investing directly in U.S. Treasury bills rather than government money market funds.
For one, no fees are associated with T-bills as compared to government money market funds. "Why own a money market fund?" Swedroe asked. "Just go buy T-bills yourself. Why do you need to pay even a low fee?"
Plus, he noted a potential tax issue for those investing in government money market funds. "A lot of these money market funds don't invest in Treasuries that are exempt from state and local taxes," he said. "They do repos."
Income from repos held in a government money market fund is subject to both federal and state income taxes, while income from direct ownership of government securities like Treasuries is exempt from state taxes, according to an Income Research + Management blog.
"Just go buy the bill yourself or buy a Treasury bill fund," said Swedroe.
The JPMorgan 100% U.S. Treasury Securities Money Market fund had a 7-day yield of 4.97% as of Oct. 20.
Another Interest Rate Play: Laddering CDs
Chris Mankoff, chief portfolio strategist with JTL Wealth Partners, recommends laddering certificates of deposit (CDs) as a way to lock in short-term rates.
Laddering allows you to take advantage of rising interest rates on longer-term CDs, while still having access to your money on a regular basis.
With laddering, you might invest an equal amount of money in CDs with different maturities, say six months, one year and two years. Then as each CD matures, you could reinvest the proceeds in a new CD with a longer maturity.
According to Bankrate, a six-month CD from Popular Direct was yielding 5.51% as of Oct. 18. A one-year CD from BMO Alto was yielding 5.5% as of Oct. 18. And a two-year CD from Bread Savings was yielding 5.00% as of Oct. 18.
A Fixed-Income Investment Strategy
George Padula, the chief investment officer of Modera Wealth Management, recommends a fixed-income investment strategy focused on quality, duration, diversification and income.
"Keep your quality high," he said. "By combining Treasuries, high-grade corporate bonds, high-grade foreign bonds and even adding in higher yielding bonds, one can still have a weighted average credit quality that is investment grade."
Others are also fond of this strategy. "To protect yourself in this environment where we may not have the 'soft landing' the market has predicted all year, it may be a great time to keep your duration low, your credit quality high and keep some 'dry powder' to invest on the other end," said Bishop.
Mankoff suggests looking at ultra-short-duration fixed-income investments "because they are far less sensitive to rising interest rates than longer-term fixed-income investments."
Duration is a measure of a bond's sensitivity to interest rate changes, according to a BlackRock blog post. The higher a bond's duration, the more its price will change when interest rates move.
The US Aggregate Bond Index has a duration of about six years. For every 1% increase in rates, the Aggregate Bond Index would decline in price by about 6%. "Keeping duration around five years means the portfolio will experience about 17% less interest rate risk than the index, all things being equal," Padula said.
Padula's advice: "Don't reach for risk."
Diversify Fixed-Income Investments, Too
Investors also need to be mindful of being diversified with respect to their fixed-income investments. "Diversification helps smooth out turbulent markets," said Padula. "Treasuries, corporate bonds, U.S. bonds, foreign bonds, taxable bonds, municipal bonds, short-term and longer-term bonds, all have to be a continual part of a fixed-income strategy. You can't try to time the market and flip from one to the other and then another."
Padula also reminds investors that it's not just what you earn, but what you keep. "Don't ignore tax equivalent yields that municipal bonds deliver," he said. A 3% tax-free municipal bond yield equates to a 4.2% taxable yield for those in the 28% federal income tax bracket, and 4.5% for those in the 34% bracket.
Investing In Stocks Amid Rising Interest Rates
For his part, Johnson said investors shouldn't disregard stocks. "Not all stocks are created equally with respect to the influence of rising rates," he said.
In their book "Invest With the Fed," Johnson and his co-authors and partners at Economic Index Associates, Gerald Jensen and Luis Garcia-Feijoo, examined stock returns from 1966 through 2020.
"We found that certain stock market sectors perform better than other sectors when rates are rising," he said.
The best-performing sectors when rates are rising are utilities (8.4% annually), energy (7.9%), consumer goods (7.8%), and foods (6.5%).
"People need to eat, put gas in their cars, brush their teeth and heat their homes regardless of the direction of interest rates," he said.
Meanwhile, the worst-performing sectors during rising rate environments are autos (-1.3% annually), durables (0.1% annually), retail (2.8% annually) and apparel (2.8% annually).
"On average, during restrictive periods, we found that sectors relying on discretionary spending levels languished relative to sectors producing necessities," said Johnson.
Selecting Stocks In A Rising Interest Rate Environment
But that only tells part of the story. "Based on our research, the EIA team created a financial model that selects stocks for Federal Reserve monetary environments based on firm-specific metrics," he said.
One example of such a metric, Johnson said, is a firm's cash to total assets (Cash/TA) i.e., the firm's cash holdings. In an expansive environment when rates are falling, Johnson said, the cash holdings variable is assigned no weight as it is deemed relatively unimportant to stock performance. "The economic rationale supports zero weight because a firm's level of cash holdings is relatively inconsequential during periods when the Fed is signaling that funds will be readily available," he said.
In contrast, during restrictive environments when rates are rising, Johnson said the cash holdings variable is assigned maximum weight because the metric is expected to have a leveraged effect during such environments. "That is, when the Fed signals that fund availability is going to be constrained in the future, having a higher level of cash holdings becomes more beneficial for a firm," he said.
Similarly, during restrictive monetary environments, Johnson said firms with relatively strong balance sheets, greater market presence and greater financial stability tend to outperform.
Top-Performing Stocks: Value Firms
Specifically, the top-performing firms during restrictive monetary periods tend to be value firms (those with relatively low price multiples), that have relatively strong cash positions and relatively low debt ratios. "In general, restrictive monetary environments have generally favored stocks with less speculative elements, whereas firms with more risk elements and greater growth prospects have generally shown superior performance during expansive environments," Johnson said.
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Given this evidence, Johnson said "equity investors may want to tilt their equity portfolios to firms with these characteristics when interest rates are rising."
For his part, Padula recommends seeking income from dividends, too. He notes, "2023 will mark the 14th consecutive year of dividend increases for the Standard & Poor's 500 index."
ETFs With Market Leaders And Dividends
Padula said that dividends for the S&P 500 from the end of 2007 through the end of 2022 averaged 6.5% annual growth, meaning dividend income more than doubled over those 15 years. "Dividends can serve as an anchor to windward in an uncertain economic environment," he said.
Bishop said the current environment could be a good time to buy solid companies that are market leaders and that pay good dividends as well.
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Some ETFs that fit that description include SPDR S&P Dividend ETF, Vanguard Dividend Appreciation ETF, iShares Select Dividend ETF, ProShares S&P 500 Dividend Aristocrats ETF, Vanguard High Dividend Yield ETF, Schwab U.S. Dividend Equity ETF, and WisdomTree U.S. Quality Dividend Growth Fund.
Bottom line for Bishop: "Make sure you know the risk. Don't just try to find the highest-yielding investments. Many times you are getting paid for taking a risk or having much less liquidity."
The Illiquidity Premium
Investors might also consider diversifying into assets that are less correlated with other parts of their portfolio. That could include reinsurance or secured private debt.
Swedroe, for instance, has in his portfolio a large allocation to Cliffwater Corporate Lending fund, which is an interval fund that invests primarily in senior secured corporate loans.
Managed by Cliffwater, the fund uses a multimanager private debt platform and invests in senior secured loans to middle-market companies, with an average loan-to-value ratio of around 40%.
All loans in the fund are floating-rate loans based on the Secured Overnight Financing Rate (SOFR), with a maturity of one or three months. The current yield on the fund is about 11.2% net of fees and has a duration of virtually zero, Swedroe said. The SOFR is a broad measure of the cost of overnight borrowing collateralized by Treasury securities.
According to Swedroe, the loans have strong protections including security interests and restrictive covenants. About 94% of the fund is allocated to first lien senior secured loans. The fund focuses on directly originated loans and bonds, Swedroe said. And it aims to generate income and total returns less correlated to equity markets.
Since inception in March 2019, the fund has generated a net annualized return of 8.61%.
Be aware, though, that private credit funds such as the Cliffwater Corporate Lending fund are illiquid. That means investors cannot easily redeem their shares.
You Don't Need Liquidity For All Assets
An interval fund like Cliffwater Corporate Lending is a type of investment fund that combines features of open-end and closed-end funds. Like a closed-end fund, an interval fund raises a fixed amount of capital through an initial public offering and does not continuously offer new shares. However, unlike a traditional closed-end fund, an interval fund provides limited liquidity to investors by periodically offering to repurchase a portion of its outstanding shares at net asset value (NAV). The Cliffwater Corporate Lending fund offers quarterly repurchase offers where investors can sell back up to 5% of the fund's outstanding shares at NAV.
Additionally, the funds are subject to credit risk. That means borrowers could default on their loans.
Weighing Risk In Private Credit Funds
Swedroe believes the risks of investing in private credit funds such as the Cliffwater Corporate Lending fund are outweighed by the potential rewards. The fund has a long history of generating returns with relatively low volatility.
In short, the fund offers retirees and other investors a good way to generate income with low credit risk, preserve capital and reduce overall portfolio risk, he said. "In my opinion, it's the best option for those who understand that you don't need liquidity for all of your assets. Especially if you're withdrawing only a few percent a year, typically 5% or less," said Swedroe. "This is one of the biggest mistakes investors make, overvaluing liquidity without good reason and missing an opportunity to earn a large illiquidity premium."
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