How rising interest rates will affect your portfolio

inflation

Quick note on a sale we’re having: You may have noticed that I recently opened a store at Intentional Retirement.  Almost everything I do at the site is free, but I do have a few things for sale (and several new products on the way).  To celebrate the opening, I’m having a sale on the current flagship product, the If Something Happens to Me Kit.  Thousands of people have purchased the kit over the years as a tool to fill holes in their planning and organize their financial, legal and insurance affairs.  Through Friday of next week (June 28), if you purchase the kit, I’ll throw in a free copy of my book The Bell Lap: The 8 Biggest Mistakes to Avoid as You Approach Retirement (normally $14).  A few questions you might have:

Q: If I buy multiple copies of the kit, do I get multiple free copies of the book? 
A: Yep.  Buy some for friends and family.

Q: Can I forward this email to anyone I know who might be interested?
A: Absolutely.

Q: Will the free book show up in my order details when I place the order?
A: Nope, but it will be in the box when your order arrives 

Q: What if I have some other question?
A: Just email me at joe@intentionalretirement.com or give me a call at 1-888-391-4344

And now a look at rising interest rates…

How rates got so low

In response to the global financial meltdown in 2007-2008, the Federal Reserve lowered short-term interest rates to historic lows in an effort to stimulate the economy.  When that didn’t seem like enough, they started a program of “Quantitative Easing” where they began buying bonds in an effort to lower rates further. 

As you might imagine, when a buyer shows up and says “Give me a few trillion dollars of those” the price of “those” tends to rise (more demand = higher prices).   With bonds, when prices rise, rates fall.  So as the Fed artificially pushed up prices, rates fell further.  That was good news if you were borrowing money for a house.  Bad news if you were trying to earn a little interest on your money market or CDs.

Investors responded to the 2007-2008 crisis by shifting a disproportionate amount of their money from stocks to bonds.  Seeing your stock portfolio drop by half can go a long way toward making you a lover of all things fixed income.  With everyone buying bonds, prices rose further and rates fell further.  So that brings us to today, where rates are extremely low and most investors are overweight bonds.

What happens when rates rise (as they have started to do)? 

Of course the Fed can’t keep printing money and using it to buy its own debt forever.  “Wouldn’t be prudent” as Bush 41 would say.  When the economy gets better, Bernanke has promised to take away the punch bowl.  When that happens, the biggest bond buyer in the market will put away its checkbook and those artificially high bond prices will start to fall.  As prices fall, rates will rise.  Said another way, all those bonds that people have bought over the last 5 years could start to lose money.

How can I protect myself?

Chairman Bernanke came out this week and said that the economy is looking healthy enough that the Fed will likely wind down its QE program by the middle of next year.  Right on cue, rates started to rise and bond prices fell.  So how can you protect yourself against rising rates?

First, review your asset allocation.  As I said earlier, many investors swore off stocks after 2007 and shifted most of their money to bonds.  That could expose them to significant losses if bond prices fall.  Look at your portfolio and see what percentage is in things like bonds, stocks and cash.  Work with a trusted adviser to make sure that the balance is appropriate for your circumstances and risk tolerance.

Second, review the duration of your bonds.  Not all bonds respond the same to rising and falling interest rates.  Duration measures how sensitive a bond is to a change in rates.  The higher the duration, the more sensitive the bond.  If a bond (or bond fund) has a duration of 10, it will typically fall in value by 10% if rates rise by 1%.  If it only has a duration of 3, it will fall by 3% if rates rise by 1%.  It stands to reason then, that if you expect rates to rise, you should gravitate toward lower duration bonds. 

Third, don’t panic.  Markets tend to overreact.  Rather than focusing on the daily headlines, the best recipe for a good night’s sleep is to make sure that you have a well balanced, diversified portfolio that is appropriate for your circumstances and goals.

Any other questions about bonds?  Put them in the comments section below and I’ll do my best to answer them.  Have a great weekend!

~ Joe

One Response to “How rising interest rates will affect your portfolio”

  1. Ron September 27, 2013 at 8:31 pm #

    As a very conservative saver, as opposed to a conservative investor I have been waiting for these rising interest rates for years. I keep hearing that the Fed can’t keep printing money forever but I’m starting to have my doubts about that 🙂 Seriously, what would stop them from continuing with the QEs? Why would 32 trillion in debt be worse than 16 trillion in debt when they’re buying securities from themselves with money they created out of thin air? Think about that, it really makes you question the whole concept of money…

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