We finally have liftoff. This week, after months of anticipation, the Federal Reserve (Fed) initiated its first rate hike in nearly a decade, raising the Fed Funds Rate by 25 basis points (bps).
Why not a bigger blast off? The Fed has made it clear that rate “normalization” will happen gradually, meaning rates will likely remain below historical averages for the foreseeable future. But while it may take years to get back to a 4 to 5 percent Fed Funds rate, higher rates are on their way.
The good news for investors is that just a few simple actions can help you prepare your bond and equity portfolios for this new rising rate environment. In the wake of the Fed’s decision, here are four such moves you may want to consider.
1. Consider Your Duration
While longer-duration bonds can provide portfolio diversification benefits, shortening the duration of your bond portfolio can potentially help manage losses due to rising interest rates.
Remember, duration is a measure of a bond’s sensitivity to interest rate changes. The longer the duration, the more a bond’s price is impacted. When interest rates change, a bond’s price will change in the opposite direction by a corresponding amount. For example, if a bond’s duration is 5 years and interest rates rise 1 percent, you can expect the bond’s price to fall by approximately 5 percent. Therefore, bonds with higher duration generally have greater price volatility and the potential for losses when rates rise.
2. Focus on Credit
Instead of owning only Treasuries, you may want to focus on adding credit exposure. Credit exposure adds credit risk (the risk that the issuer won’t pay you back) to a portfolio, but it mitigates some interest rate risk. In addition, investors are compensated for taking more credit risk with higher yields, so increasing exposure to higher quality credit risk may enhance income and offset potential price declines due to rising rates.
3. Shift to Cyclical Sectors
It’s important to remember that when rates rise, it’s not just bonds that are affected. Equities are affected too. Higher rates mean that borrowing money becomes more expensive, so it’s harder for businesses and consumers to finance everyday needs. As such, traditionally defensive sectors, like utilities and telecommunications, typically become increasingly vulnerable in a rising rate environment due to their existing large debt positions. At the same time, higher rates generally are a sign of an improving economy, boosting the case for adding exposure to cyclical sectors, which have tended to outperform when the economy is strong.
I prefer to get cyclical exposure through two sectors: U.S. technology and U.S. financials (excluding rate-sensitive REITs). With their large cash reserves, U.S. mature tech companies are much less vulnerable to rising rates than companies in more debt-laden sectors mentioned above. In addition, tech sector revenues may increase if economic growth continues to expand and consumers and businesses spend more. Meanwhile, for some financial institutions, like banks, rising rates could mean higher profits, as net interest margins may increase.
4. Seek New Sources of Income
You may also want to take a look at your dividend strategies when interest rates rise. Although traditional high dividend payers (think the utilities and telecom sectors) have performed strongly in recent years, they’ve become quite expensive by most valuation metrics. And the previously low interest rate environment paved the way for many of these defensive businesses to load up on debt to expand their operations, while continuing to pay high dividends to investors. As such, many of these companies will likely come under pressure when rates rise.
In contrast, dividend growth stocks have historically demonstrated less interest rate sensitivity and may be an attractive way to maintain yield in a rising rate environment. In contrast to high dividend payers, they tend to be more reasonably valued and have more potential to sustainably grow dividends over time.
So, although rates are expected to moderately increase, you can prepare your portfolio now for a rising rate environment by considering simple actions such as these. These simple steps may help to insulate your investments while also capturing new opportunities. Learn more about these four strategies for rising rates, and the exchange traded funds (ETFs) that can help you put them into action, at iShares.com/iThinking.
Funds, such as the iShares Floating Rate Bond ETF (FLOT), the iShares Short Maturity Bond ETF (NEAR) and the iShares 1-3 Year Credit Bond ETF (CSJ), can provide credit exposure with short duration. Meanwhile, the iShares U.S. Technology ETF (IYW), the iShares U.S. Financial Services ETF (IYG) and the iShares Core Dividend Growth ETF (DGRO), can provide exposure to the U.S. technology sector, the U.S. financials ex-REITs sector and dividend growers, respectively.
Heidi Richardson is a Global Investment Strategist at BlackRock. She is also Head of Investment Strategy for U.S. iShares.
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Investing involves risk, including possible loss of principal.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. The Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates.
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