Now that rising interest rates are looking increasingly likely for 2015, now is the time to start structuring your portfolio accordingly to maximize returns and minimize losses. Even if the Federal Reserve doesn’t start monetary tightening by raising borrowing costs well into next year, it is wise to begin making your moves before the Fed makes theirs.
Although rising interest rates have a negative impact on certain types of both stocks and bonds, rising rates also generally coincide with a growing economy — at least in the early stages of monetary tightening. Therefore, an investor need not panic and jump into cash. Instead, a simple strategy of rotating into the right kind of securities and out of the wrong ones can strike a prudent and profitable balance.
For example, while there is no perfect mechanism for timing the rotation out of potential laggards and into the coming leaders, we can take a look at history as a guide. The last time rates were on the rise was from 2004 to 2007, from a low of 1% in June 2004 to a high of 5.3% through July 2007. Stocks were positive for each of those calendar years.
However, there are significant differences in performance between the best and worst funds for rising interest rates.
Best & Worst Funds For Rising Interest Rates: Growth vs Value
If we begin by dividing stock funds into the two broad categories of growth and value, we gain insight into the behavior of broad market equity prices in a rising-interest-rate environment, as well as ideas for portfolio management.
In general, it is wise to reduce exposure to growth stocks and increase exposure to value stocks when interest rates are rising. Value funds tend to consist of companies with strong current cash flows that might slow in the future, while growth stocks have little or no cash flows today but potential for increasing cash flows in the future. Therefore, because the stock market is a forward-looking, discounting mechanism, the expectations for rising interest rates (and thus the cost of borrowing) will shrink future growth prospects, along with growth stock prices.
To compare, I’ll use Vanguard Growth Index (VIGRX) as a proxy for growth stocks and Vanguard Value Index (VIVAX) for value stocks in each of the calendar years when interest rates were most recently rising:
- 2004: Growth 7.2%, Value 15.3%
- 2005: Growth 5.1%, Value 7.1%
- 2006: Growth 9.0%, Value 22.2%
- 2007: Growth 12.6%, Value 0.1%
As you can see, Value wins the rising interest rate battle vs. growth here. It loses only in 2007, but this is primarily because late 2007 saw financial stocks, generally a value sector, get slammed in the face of the credit crisis that began that year.
Best & Worst Funds For Rising Interest Rates: Sector Funds
Now that we have a broad understanding of economic and market conditions during periods of rising interest rates, let’s take a look at the best and worst sector funds for that environment.
The narrative of growth falling out of favor and value coming into favor carries over to sectors in periods of rising interest rates. For example, energy and utilities, which are generally value-oriented sectors, tend to outperform growth-oriented sectors, such as technology and consumer cyclicals.
For proxies here, we’ll use Vanguard Energy Index (VGENX) and Fidelity Select Technology (FSPTX):
- 2004: Energy 36.7%, Technology 0.43%
- 2005: Energy 44.6%, Technology 4.9%
- 2006: Energy 19.7%, Technology 7.5%
- 2007: Energy 37.0%, Technology 19.8%
In this comparison, energy is clearly the best sector during the four-year period of rising rates and technology is the worst. For your knowledge, I narrowed the best and worst choices here by first looking at these and other sectors, including consumer staples, consumer cyclicals, financials, utilities, real estate, health and natural resources.
Best & Worst Funds For Rising Interest Rates: Bond Funds
When it comes to bond prices and interest rates, the analysis seems simple at first: Bond prices move in opposite direction of interest rates; and the longer the maturity, the greater the divergence. However, there are other moving parts, such as employment and inflation, that add complexity to bond price forecasting.
It is generally true that avoiding long-term bond funds and holding short-term bond funds is wise when rates are rising. Due to the correlation between rising rates and inflation, an investor also can do well with inflation-protected securities. High-yield bond funds move similar to stocks in price and can have severe declines in price when the bear market hits; therefore, we will not include them in our analysis here.
Sticking to our most recent period of rising interest rates, from 2004 through 2007, I’ll use Vanguard Long-term bond Index (VBLTX), Vanguard Short-term Bond Index (VBISX), Vanguard Inflation-Protected Secs (VIPSX) and Vanguard Total Bond Market Index (VBMFX) as historical proxies for long-term bonds, short-term bonds, and total bond market, respectively:
- 2004: Long-term bonds 8.4%, Short-term bonds 1.7%, Inflation-protected 8.3%, Total Bond 4.2%
- 2005: Long-term bonds 5.3%, Short-term bonds 1.3%, Inflation-protected 2.6%, Total Bond 2.4%
- 2006: Long-term bonds 2.7%, Short-term bonds 4.1%, Inflation-protected 0.4%, Total Bond 4.3%
- 2007: Long-term bonds 6.6%, Short-term bonds 7.2%, Inflation-protected 11.6%, Total Bond 6.9%
Key takeaways here are that long-term bonds didn’t lose to short-term bonds until 2006 and 2007 and inflation-protected securities only won in 2007. The Vanguard Total Bond Market Index fund is never the winner or the loser. Therefore, investors may want to play the middle of the road by sticking with a broad index fund that will provide exposure to all categories of bonds, from government to corporate to municipal, and to all maturities and credit quality.
As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.
