Following the financial crisis in 2008, the ensuing “flight to quality” where investors poured funds into government debt securities, and two bouts of heavy quantitative easing by the U.S. Federal Reserve (large-scale buying of government debt and other fixed income securities to provide liquid funds to banks and other institutions), investors are now faced with historically low interest rates. Further, the Fed has stated that it intends to keep interest rates low for an extended period of time, at least until late 2014.
In a low interest rate environment, there are two key things to consider:
1) Today’s historically low interest rates primarily hurt conservative investors and those with an income objective.
National Average 1-yr CD: 0.33% National Average 5-yr CD: 1.12%
One Year T-Bill: 0.21% 10 Year Treasury Note: 1.77%
Vanguard PRIME Money Market: 0.04%
2) With rates now near zero, it is inevitable that a period of rising interest rates will eventually follow. However, the timing of future rate hikes is impossible to estimate with certainty and the current interest rate environment may persist for several years.
As an investor, navigating this difficult, low-interest rate environment can be quite challenging. Below we’ve provided a brief list of some actions to consider, as well as some to avoid.
What Not to Do…
- Do not put money solely into longer-term bond funds. The market value of these investments will get hit the hardest when rates rise.
- Don’t base decisions on the past total return of bond funds. The environment in which these returns were generated is not the same as the current environment and is unlikely to be replicated moving forward. Focus more on trailing yield measures.
- Do not put a large portion of your portfolio into dividend stocks or high yield (junk) bonds to increase expected return without weighing the risk of these investments.
- Do not purchase variable annuities or other structured, long-term, and potentially illiquid investment vehicles under the premise of a guaranteed rate without fully considering suitability. Almost all variable annuity contracts will involve a severe penalty for early withdrawal, hefty fees, and unfavorable terms to receive the “guaranteed” rate.
What to Do…
- Reduce duration in bond and CD investments. Duration is a measure of the sensitivity of bond prices to changes in interest rates. Lower duration indicates a smaller fall in value when rates rise. The major determinants of duration are maturity and coupon rate. Securities with short maturities and higher coupons will have shorter durations. Duration information is readily available on the websites of bond funds or from investment services such as Morningstar.
- With bonds and CDs, ladder the investment maturities so some money is always coming due and can be reinvested as rates begin to rise.
- Diversify smaller portions of your fixed income portfolio to include some exposure to floating rate bonds, corporate bonds and unconstrained bond funds after carefully weighing the extra risks of these investments.
- Review the track record of the bond funds you are invested in to determine whether or not those funds have a history of holding up in previous rising interest rate environments.
- When investing in bond funds, read the manager’s recent investment commentaries and determine whether they are aware of and are taking measures against a potential rising interest rate environment.
- Before making an investment decision, always consult an independent, fee-only investment advisor who will accept fiduciary responsibility and act solely with your interests in mind.