Rising interest rates, once considered a thing of the past, are finally here.
Just one month ago, the benchmark 10-year Treasury Note was yielding about 1.85%, and now rising interest rates have quickly pushed that up to 2.2%. Similarly, a 30-year mortgage has spiked to 4% from about 3.75% a month or so ago.
So what do rising interest rates mean for investors, and how can you prepare your portfolio?
Here’s your a simple survival guide to ensure you’re prepared:
Rising Interest Rates and Bonds
The most common thing people hear regarding rising interest rates is that when the rates go up, bond investments go down. That’s technically true, but here’s why: Newer bonds that yield a better interest rate will be in more demand while older debt with a lower yield will be less valuable on the open market.
Why would you want old bonds with lower yields, unless they were cheaper?
This is important to remember amid all the talk of rising interest rates, because if you’re holding a bond to maturity and just collecting the interest payments, then that’s not a big deal. You only lose principal if you decide to sell — and if you accept someone else’s bid that’s lower than the bond’s “par value.”
If you own individual corporate or government bonds, your only risk is if the borrower actually defaults — and if you’re in investment-grade bonds or U.S. Treasuries, that is nigh impossible.
So if this describes you, don’t sweat the rate hikes.
Sadly, the majority of investors own bond funds, not individual bonds … and those funds constantly turn over their holdings via sales. Thus, they are very much exposed to interest-rate risk and a loss of principal as a result.
By way of example, the Vanguard Long-Term Bond ETF (NYSEARCA:BLV) has lost about 6% in the last month as rates have started to pick up in anticipation of Fed tightening. If this trend persists, so will losses to bond funds like BLV.
That means you should tread very carefully in long-term bond funds, because yields right now aren’t big enough to offset significant losses; the BLV, for example, has a yield of just 3.75% annually so the benefit of distributions has been more than offset by principal losses in the last month alone.
So what’s the alternative for a bond investor?
Well, short-term bond funds are much safer because their more immediate maturity makes them less susceptible to rate changes. Of course, they also yield much less … so even if your money is safe, it’s not exactly growing much if you’re picking up a yield of, say, 1%.
Check out the the Vanguard Short-Term Bond Index Fund (MUTF:VBISX) as one example. Expenses in this bond fund are super cheap at 0.2% ($20 on $10k invested), and the fund has been far less volatile YTD — in fact, it is actually slightly in the green since January principal-wise despite rising rates lately. It has a yield of only about 0.9% right now, but at least your principal is safe from interest-rate risk.
Oh, and one last thing: Watch out for junk bonds in a rising-rate environment. It’s tempting to chase their high yields, but remember that the companies issuing junk debt have a high cost of borrowing for a reason. Many of these troubled borrowers will not have much wiggle room, and a higher debt service in a higher-rate environment could be very painful — leaving you holding the bag if these firms default.
Rising Interest Rates and Stocks
The middle ground, as it so often has been in recent years, appears to be in bond-like stocks — blue chips that can yield close to (or better than) investment-grade bonds but are free of direct interest-rate risk.
Of course, there are plenty of other risks to the stock market … and companies like McDonald’s Corporation (NYSE:MCD) and The Coca-Cola Co (NYSE:KO) have been making headlines lately because of their unique struggles, so always remember that the stock market is far from a sure thing.
But I still like quality stocks vs. the interest rate risk of long-term bond funds or the anemic returns of shorter duration bond funds.
If you do your homework, you can find some good dividend stocks or dividend-focused stock funds that are a fair value and relatively stable right now. One I personally am watching is the iShares International Select Dividend ETF (NYSEARCA:IDV), which yields about 3.7% right now and has a global flavor at a time that U.S. markets are increasingly volatile and opportunities present themselves overseas.
You can, of course, pick individual stocks … but make sure you’re looking beyond simply yield. Even dividend darlings like MCD and KO can disappoint (and they are!) on the business front. Furthermore, high-yield stocks with unsustainable payout ratios should be avoided in favor of quality dividend payers.
And if you own bond-like stocks that only yield about 2% or so? Well, you may have to be prepared for some pain.
After all, investors flocked to these companies amid a low-interest-rate environment in the quest for modest distributions. But now that these traders can get that yield in Treasuries instead of volatile equities … well, they could see a sharp selloff as a result.
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not hold a position in any of the aforementioned securities.