What a wild ride interest rates have been on over the past year and a half! The federal funds rate has soared from its multi-decade low near nil early last year to a target rate of 5.33% as of last month.
Other interest rates like those on mortgages, bonds, money market funds, and credit cards, have grown similarly, but more dramatically.
Income investors have certainly seen the impact of rising rates, too. While higher rates translate into higher yields on new income-generating investments, they also crimp the value of your current dividend-paying stocks and bonds. The bigger the stock's yield or the longer the bond's term, the greater the adverse impact. Some investors' portfolios are now nursing rather serious unrealized losses as a result.
If you're one of these investors, don't beat yourself up too much; it's not always clear when rates are going to change. And the speed and scope of the interest rate increases since the middle of last year were jaw-dropping.
There are a couple of things you'll want to keep in mind, however, the next time you find yourself in a similar situation and you want to shield your portfolio from this turbulence.
The best defenses against soaring interest rates
Although the underlying premise is the same in both cases, the best way to teach this lesson is by splitting up the income-focused portion of your portfolio into two separate groups: your dividend stocks, and your bonds or similar debt-based instruments.
Let's start with the bonds. Veteran bond investors understand that higher interest rates generally reflect higher risk from the bond's underlying issuer. That's why government-issued Treasuries and T-bills pay relatively less than corporate-issued debt with similar maturities. Should governments have to, they can simply print more money to pay their obligations. Corporations can't do the same.
Overnight federal funds rate, data by YCharts.
Risk isn't the only thing reflected by different interest rates, though. The further away a bond's maturity date is, the higher the yield. This higher yield offsets the effective risk an investor takes on by committing to a bond for a longer length of time.
You can always sell a bond, but you're only guaranteed the full return of the bond's par value upon its maturity. In some cases, that's as far as 30 years away. Other, better opportunities might surface in the meantime.
Separately but simultaneously, while the stated interest rate on a bond or T-bill doesn't change once issued, the effective yield changes by virtue of a changing market price. A bond's effective yield (for a new owner) is inflated by lowering the market value of the bond itself. Conversely, a bond's effective yield goes down when the underlying market value of that debt instrument rises.
That's why yields on bonds ebb and flow every day, even if just a little. These changes reflect the prevailing market-based rates at that time. The kicker: The further away a bond's maturity is, the bigger the underlying change in the bond's value.
It's a lot to think about. In fact, it's too much to think about, and far too much to predict. So, your best bet is to position your bond portfolio in such a way that doesn't require you to do so. A bond ladder does exactly that.
In simplest terms, creating a bond ladder just means the maturity dates on the entirety of your debt-based instruments are spread out as much as possible. Your nearest-term bonds might mature in a matter of months, and will have the lowest yields. Your highest-yielding fixed income, on the other hand, may not mature for years (if not decades). Then there's all the stuff in between. The only thing you have to do is replace these holdings with similarly timed positions as they mature.
Image source: Getty Images.
Maintaining such a bond ladder might mean you're buying bonds at seemingly low interest rates. Indeed, it likely will mean exactly that. That's OK, though. As the rate environment changes, you'll be locking in future debt holdings at higher rates. The approach means your overall average yield will more or less reflect the market's average interest rate at any given time.
Of course, you can overweight your near-term or intermediate-term or long-term maturities to fit your particular situation. Just be wary of trying to squeeze out more yield than the market is readily giving you. That often requires taking on more risk than many investors realize they're taking on.
What about stocks?
As for the dividend stock section of your income-producing portfolio, the idea is the same as above: You want to diversify. Only in this case, there are no maturity dates to diversify.
When it comes to dividend-paying stocks, the diversity comes in the form of the underlying sectors being represented, payout ratios, the amount of debt the underlying company services, and the growth rate of a company's dividend. These are all factors that can affect not only the continued payment of a dividend, but also the price of the stock itself.
And we've certainly seen the impact of not diversifying dividend stocks since early 2022. Leading up to that point, high yields were a big priority. But some of these highest-yielding dividend stocks have lost the most value in the meantime.
The turbulent economy is exposing the fragility of these companies and their stocks, which are cheap for a reason. The pessimistic premise applies to their high dividend yields as much as it does to their valuation.
Put more directly, don't be so quick to dismiss that powerhouse name with a modest dividend yield of less than 2%. That stock could well hold up much better than higher-yielding alternatives when times are tough.
A framework you can trust staves off mistakes
Boring? Maybe a little. Such strategies also pose the possibility of below-average investment income at first. In the long run, however, the slightly lower average yields you'll experience when shielding your portfolio's interest rate volatility could actually boost your overall bottom line.
These frameworks allow you to confidently stick with a plan (and a pick) when other investors are panicking. We often make our worst decisions when we panic, since that's when we're most likely to take our eyes off the bigger picture.
As always, keep things simple and make sure they work for you.
