Will the Federal Reserve finally begin to increase interest rates in 2015? Many experts think so.
What will rising rates mean for you as an investor? We asked three of our analysts what moves investors should make as rates begin to rise, and here is what they had to say.
Selena Maranjian: Now that the Federal Reserve is done with its quantitative easing program, we can expect it to start raising interest rates, though it's not clear when that will happen. Rising rates will be good for some and less good for others, and might make you tweak your portfolio a bit.
For starters, obviously, higher rates will be welcome news for those who would like to earn some non-negligible interest on our bank accounts, CDs, etc. Savers have suffered through minimal interest for many years. Borrowers have had it good, but rising rates will put pressure on folks seeking mortgages and on companies needing to borrow money.
Meanwhile, rising interest rates are generally bad for bonds and good for stocks, so you might want to reassess any bond holdings in your portfolio. If you hold actual bonds, and not bond funds, and you aim to hang on until maturity, then interest rate changes won't affect you. You should eventually receive what you were promised when you bought the bond. But many folks buy bond funds, which offer diversification across many bonds and are often managed by bond-savvy pros. The problem is that as new bonds are issued at higher interest rates, existing bonds, with their lower rates, become less attractive and fetch lower prices when sold. Longer-maturity bonds will be more impacted than shorter-term ones.
So what should you do in anticipation of interest rates rising? You might favor shorter-term bonds, and you might pare back your bond holdings -- especially if you are bond-heavy. But bear in mind that diversification across stocks and bonds is smart for many of us, especially those in or nearing retirement. Even though bond prices might drop some, bonds aren't always bad investments in rising-rate environments. In bond funds, for example, interest payments arrive, are reinvested, and can boost returns.
Dan Caplinger: Investors will feel the impact of higher rates across the markets. As Selena rightly pointed out, higher rates will hurt bonds and other fixed-income investments. They could hurt some dividend-paying stocks as well, so you should make sure you're not overexposed to particularly vulnerable companies in that segment.
Over the past several years, even the most conservative investors have had little choice but to pile into dividend stocks to generate the income they need from their investments. That has pushed up valuations substantially, with many blue-chip dividend names trading at 20 or more times their earnings. Given that growth prospects for some of those massive companies are somewhat limited, such high earnings multiples aren't sustainable without high investor demand. But as rates on bonds and other safer investments rise, conservative investors will have greater incentive to shift out of dividend-paying stocks, potentially returning them to more historically consistent valuations and causing some short-term share-price declines for those stocks.
In general, the stocks with the least growth tend to be the most sensitive to interest rates, as they effectively trade like bonds. On the other hand, dividend stocks that have good track records of growing their payouts over time should provide more protection, as rising rates could actually accelerate dividend growth. Regardless, dividend investors need to keep a close eye on the Fed's actions in the coming year.
Matt Frankel: If it looks like a rate increase is imminent, it might be a good time to consider exiting any highly leveraged investments, especially mortgage real estate investment trusts. To understand why, consider this simplified explanation of how these companies make their money.
Mortgage REITs buy mortgage-backed securities with long-term maturities (15 or 30 years) and finance the purchase by borrowing money at cheaper short-term rates. So if a company buys a basket of 15-year mortgages with an average rate of 3%, and finances the purchase by borrowing at 1% interest, the 2% "spread" represents the profit.
However, when rates rise, the cost of short-term borrowing increases instantly. But the mortgage-backed securities these companies already own will still pay the same interest rate, so the spread can erode (or even become negative) rather easily. Since most mortgage REITs use leverage ratios of five-to-one or more, even a limited rate increase can take a big bite out of the profitability.
Of course, this is a simplified example, and most mortgage REITs are hedged to some degree against rising rates. However, once rates start to rise, their profitability becomes very uncertain, and it will be a good time to exercise a little caution.