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Q&A: How should investors prepare for rising rates?

As of 06-07-2013

John Nichol, senior portfolio manager, discusses his views on the current interest-rate environment and its impact on the markets:

Q: Is the rising-rate environment that has been talked about for so long finally here? Numerous economic statistics of late indicate this won’t be a “growth-concern’’ summer—no one’s talking “double dip” as was the case the past three summers. Improving growth expectations are one reason long-term bond yields have spiked in the past month, with the yield on the 10-year Treasury up about 50 basis points.

Another reason for the sharp move up in longer yields has been the market’s belief that the Federal Reserve may start easing off the gas sooner than previously thought—a belief fueled in part by somewhat confusing if not contradictory statements from various Fed governors, including Chairman Ben Bernanke, as well as from the minutes from the most recent policy-setting committee meeting. This has led some to conclude Bernanke and his team could begin tapering quantitative easing, i.e., the $85 billion in monthly purchases of longer-term Treasuries and agency mortgage-backed securities, as early as this summer.

In the near term, it’s difficult to envision the Fed acting quickly to undo its efforts to goose a still extremely subpar recovery—the benchmark funds rate and iterations likely will prove much “stickier’’ than actual bond yields as the Fed waits for solid signs of a sustainable stronger economy. The Bernanke regime has been clear in stating it wants unemployment at 6.5% and a longer-term inflation at 2%—with a bias for the jobless rate to fall lower depending on the quality of job growth and for inflation expectations to reach 2.5%—before it starts easing off the throttle.

In other words, the recent spike in bond yields may have come too far too fast amid investor fret and uncertainty about Bernanke’s intentions. That said, it may well be that we are entering an environment in which market interest rates start to move off what really are artificial lows because of an improving economy, and such a move for such a reason should be welcomed by the markets.

Q: What asset classes do best in such an environment? In a healthy rising-rate environment, which indicates the economy is improving, stocks and commodities tend do better than fixed income.  However, bonds that are more sensitive to the economy—so-called credit issues such as investment-grade and high-yield corporate bonds that in some ways behave partially more like equities because their value is aligned with corporate performance—also tend to outperform Treasuries and mortgages. International bonds, primarily emerging-market issues, also tend to better than government issues for similar reasons, i.e., their link to macroeconomic and corporate metrics.

Q: How should investors position themselves both for higher rates but also the continued uncertainty regarding the U.S. and global economy? One reason for the wall of worry the market has been climbing is the continued uncertainty about what the Fed will do, about what Washington will (or won’t) do, about what Europe will do, even about China. All this makes it impossible to invest just by watching corporate earnings growth. But rising interest rates will favor certain sectors versus others in the market, and certain bond classes versus others.

For 2013, higher anticipated yields driven by growth and policy expectations rather than inflation concerns should lead to higher equity valuations, strength in cyclical sectors and better corporate performance versus government bonds. As noted previously, high-yield and emerging-market bonds also should generate better relative performance than government bonds.

Thus for long-term investors, diversifying across asset classes and geographic boundaries at any time, including periods of rising rates, can improve the opportunities to capture yield and improve returns without unduly increasing the potential exposure to risk.

John L. Nichol
John L. Nichol, CFA
Senior Portfolio Manager, Head of Growth & Income Team

Also by John L. Nichol

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.
Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.
Diversification does not assure a profit nor protect against loss.
High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risk and may be more volatile than investment-grade securities. For example, their prices are more volatile, economic downturns and financial setbacks may affect their prices more negatively, and their trading market may be more limited.
International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging-markets securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.
Prices of commodities may rise and fall in response to many factors such as economic, political and regulatory developments.
Federated Global Investment Management Corp.
Copyright © 2014 Federated Investors, Inc.

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