How to Prepare Your Income Portfolio For Rising Interest Rates

Rising Interest Rates

With the Federal Reserve seemingly poised to hike near-term interest rates for the first time in what seems like an eternity, investors would be wise to consider the potential repercussions on their portfolios. While both equity and fixed-income investors have benefited by and large from declining/low rates over the past 30 years, if we are embarking on a rate reversal, the consequences on specific portfolio positions should be considered.

Income Investing Portfolio

First, one should realize that the Fed does not directly control longer-term bond yields or stock prices. As we’ve progressed through ZIRP over the past several years, the yield on the 10-year Treasury note has volleyed generally between 1.5 and 3 percent. Though the Fed Funds rate affects investor perception and may influence/affect publicly traded securities as well as lending rates, stocks and bonds continue to trade on their traditional supply/demand mechanics.

Interest rate sensitivity should be well understood. Certain stocks that hold a large amount of debt or have qualities and characteristics of bonds are most exposed during a rising rate environment. There are multiple reasons for this. As borrowing costs rise, the impact on a company’s bottom line is likely to be impacted. Also, as yields on lower risk fixed investments like bonds and cash rise there becomes a greater allure to owning them and less of an allure to own equities. It is a primary reason that stock valuations have risen on the past 5 years.

Utilities and REITs are two equity sectors that are generally sold off as rates rise. Utilities usually hold large amounts of debt, and REITs may have longer-term contractual lock ins that investors view as the equivalent of intermediate- to longer-term bonds. As we know, bond yields rise when prices fall and vice versa.

But don’t necessarily think that other stocks with robust yields are insulated from a sell off. Many widely held dividend payers are experiencing operational headwinds and may not be as bulletproof as they’ve been deemed to be in time’s past.

There has been rationality for investor gravitation to income stocks and higher-yielding bonds amidst yield starvation elsewhere. However, portfolios with extreme interest rate sensitivity may be more exposed to capital downside if rates rise faster than may be expected.

Time To Sell?

This might not require much action on an investor’s part. If one’s exposure to rate sensitive stocks is manageable, there may be little reason to churn an account. However, if an investor has capital preservation needs and is greatly exposed to REITs, long-term bonds, leveraged CEFs, or other securities that will likely see greater than average price decay during a rising rate environment, action may be advisable.

In terms of bonds, again, some investors may be able to ride the situation out with little thought to the matter. Laddered bond portfolios, even if they have long relative duration, are typically viewed as a “rate agnostic” method of combatting rising rates. If you are holding too much long-term debt, seriously consider shortening blended maturity/duration.

The Best Policy

Unless you have a solid forward thesis for how our macroeconomic situation plays out, diversification is a prudent, somewhat non-emotional way to position a portfolio. Owning stocks that represent different market sectors that may be affected differently (or not at all) by rising rates is a simple way to mitigate risk. Raising a bit of cash may also be a decent move if you think the market is overheated or headed for a material correction.

Though it appears the Fed will start to tighten monetary policy later this year, investors should not assume that armageddon will be the result. Still, one should assess the rate sensitivity of portfolio holdings, understand which securities might be more at risk, and take action if a portfolio is overexposed one way or the other.

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