09/15/2015
What Should Investors Do to Adjust Their Portfolios for a Looming Interest Rate Hike

What Should Investors Do to Adjust Their Portfolios for a Looming Interest Rate Hike

The experts are in agreement: interest rates are set to go up either in the 4th quarter of this year or early in the 1st quarter of 2016. Talk about interest rates rising has gone on for so long, it’s beginning to look like Charley Brown’s “Great Pumpkin.” One waits and waits for it to appear, but it never seems to happen. For at least the past four years, people have expected a rise in rates. But winter turns to spring, spring turns to summer, and summer to fall, and the higher interest rates never materialize.
It looks like that’s about to change. The Fed is meeting in mid-September, and all investors should make changes to set themselves up for success in a higher-interest market.

Stocks
No changes to current asset allocation mix or fund selections.

Bonds
We are recommending that clients diversify their bond holdings by positioning themselves all along the yield curve and credit quality spectrum. In addition, we’re recommending that everyone reduce expenses. If rates rise, and bond return expectations are lackluster, then the best, most reliable way to increase returns going forward is to cut costs.

Four strategies we are focusing on now are:

a) Non-U.S. bonds: The bond market outside the United States now represents an asset class that’s larger than U.S. stocks, U.S. bonds, or international stocks. Furthermore, other countries’ levels of interest rates and inflation—the two most important drivers of bond returns—have had low and varied correlations with U.S. levels since 1990. The earlier sell-off in Developed and Emerging Markets International debt pushed yield in those sectors above 5%. Examples of criteria that might be important are bond funds that are broadly diversified across Developed and Emerging Markets, have super low expenses, and hedge currency exposure.

b) Floating Rate bonds: Floating‐rate loans have an adjustable rate that goes up—or down—with short‐term interest rates. Therefore, floating-rate loan investors have the potential to enjoy higher yields if rates rise and interest rate increases have less impact on the prices of floating-rate loans. While floating-rate loans have enjoyed multiple years of strong results and huge inflows, it pays to be careful.

c) Municipal Bonds: After-tax yields on municipal bonds remain very favorable to comparable treasuries, and that’s why we like investment-grade muni bonds through very broad ETFs strategies. These ETFs can have 90% investment-grade debt and a mix of short, intermediate, and long bonds.

d) High Yield: High Yield i.e. junk bonds. Historically, junk bonds are less interest-rate sensitive than equivalent maturity investment grade debt, because high yield’s larger coupon helps offset capital loss if the bond’s price goes down. We’re more positive about high yield than we were a year ago, primarily because of big price declines in many high yield bonds, like those in the energy field. The spreads are wider than they were a year ago. Credit quality still counts, and we don’t think it pays to stretch for yield by dipping into the lower-credit quality tiers of this space.

Alternative Investments
Some of these strategies have “bond-like” low volatility, but are not correlated with bonds also not tied to the directionality of interest rates. Some alternative investments can be used as “shock absorbers” for your portfolio. Two categories we would recommend are:

a) Managed Futures: These are trend-following strategies that can take advantage of rising markets as well as falling ones across global equities, fixed income, currencies and commodities futures. If rates spike or something else dramatic and disruptive happens to bonds, managed futures can have you positioned to profit.

b) Hedged Equity: These funds can be a great way to diversify bond exposure without increasing overall risk. They are stock funds that use options to hedge or reduce stock risk. The funds should have relatively low expenses and a tenured management team.

Now that you’ve got the information, it’s time to put it into practice. Come to OptiFour for expert wealth management across a variety of markets. If you want more industry analysis and news, read our previous blogs or sign up for our newsletter.

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