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March 2017

How to position for
rising interest rates

An improving economic picture suggests the Federal Reserve will raise interest rates three or possibly four times in 2017. While rates are expected to rise gradually, the path may be policy dependent. For well-prepared investors, rising interest rates may present opportunities in both fixed income and equity markets.

Last year, the Federal Reserve (the Fed) embarked on a path of raising interest rates for the first time in nearly a decade. As data confirm improved economic conditions and U.S. inflation (both core and headline) nears the Fed’s 2% stated inflation target, additional interest rate hikes will likely follow – potentially as many as four in total this year. While global markets have been anticipating gradual rate hikes to continue, the path may be more policy dependent than in times past.

The new administration has put forth fiscal policy proposals that could boost economic growth, but also trigger higher inflation. Depending on the fate of such policies and whether we continue to see strong data in the U.S., the Fed may have to move at a moderately faster pace of rate normalization. As such, investors may want to consider positioning their portfolio accordingly.

React, don’t overact

While many bond investors may fear rising rates, there may be an upside. The Fed has been signaling plans to raise rates for over a year, and markets have been adjusting in preparation for it. When rates do rise, we expect increased market volatility over the short term, but since rising rates reflect a growing economy, it may also present opportunities for well-prepared investors.

A thoughtfully-allocated, diversified portfolio can help investors reduce the impact of rising rates as well as capture growth potential. Even as the prices of bonds fell during the last rising rates cycle (2003-2006), income payments more than offset this loss to generate a positive total return (Figure 1).

Figure 1: Bloomberg Barclays U.S. 1-3 Year Credit Bond Index Performance During the Last Rate Cycle

(June 2004 - June 2006)

Figure 1: Bloomberg Barclays U.S. 1-3 Year Credit Bond Index Performance During the Last Rate Cycle

Source: Bloomberg, Barclays, as of 2/28/17. Data from 2004-2006.
Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Prepare your bond portfolio

Broadly speaking, the current environment appears positive for U.S. corporate credit sectors, which may now operate in a more business-friendly environment. We could potentially see relaxed regulatory burdens, lowered corporate tax rates (and/or one-time overseas capital repatriation), and several industry-specific tailwinds that aid credit markets.

Many investors are concerned with how their bond portfolios will perform. Remember that bonds have two primary sources of risk: interest rate and credit risk. While it’s true that bond market prices fall as rates rise, two actions may help provide protection:

Shorten duration

Bonds with higher duration (a measure of sensitivity to interest rate changes) generally have had greater potential for losses when rates rise. Shortening the duration of your bond portfolio can potentially help manage losses due to rising interest rates.

Focus on credit exposure

Seek a better balance of risk and reward by focusing on adding credit exposure. Credit oriented bonds typically provide a greater yield cushion over Treasuries, potentially offsetting the impact of rising interest rates

Figure 2: Dow Jones Financials vs. 10 yr Treasury

Figure 2: Dow Jones Financials vs. 10 yr Treasury

Source: Thomson Reuters, U.S. Treasury, as of 2/28/2017.

Look for potential opportunities in stocks

Focus on well-positioned sectors
in a rising rate cycle

In a rising rate environment, some debt-laden defensive sectors, such as utilities and telecom, tend to underperform. In addition, these stocks have become very expensive compared to historical averages. More reasonably valued cyclical sectors, such as financials, may benefit from a strengthening U.S. economy.

Financials currently have a price-to-book ratio of about half of the broad U.S. market, and could potentially benefit from rising rates by capturing a bigger spread (profit) on the rates at which they loan money and the rates they pay depositors (Figure 2).

Consider new sources of income

Given the low return environment, equity dividends have increasingly become a more significant source of income for investors. However, a rising interest rate environment may present challenges for high-yielding equities or so- called bond-like proxies, such as utilities. Furthermore, companies that have taken on leverage in order to distribute higher dividends are particularly susceptible. For this reason, dividend growers may be well positioned and worth considering. Dividend growth strategies may offer:

  • A higher allocation to cyclical sectors that have the potential to grow alongside the economy.
  • Exposure to companies that have the potential to sustainably grow and increase dividends over time.

Please note that dividends are not guaranteed and a company’s future ability to pay dividends may be limited.

Figure 3: Sector Weights of Dividend Growers

Figure 3: Sector Weights of Dividend Growers

Source: S&P and Momingstar, as of 2/28/2017.