The much anticipated increase in interest rates has begun. Even though the Federal Reserve (the Fed) continues to buy about eighty billion dollars of our own government’s debt each month (“Quantitative Easing”), the mere mention by the Fed that it will “taper” its bond-buying in the future is enough to cause prevailing rates to rise.

 

Depending on your circumstances, rising rates could be a good thing or a bad thing. It could mean losses to investors who already own bonds and bond funds. On the other hand, higher rates are welcome news for savers looking to put some cash to work. For home buyers financing their purchases, it could mean higher monthly payments. While it is difficult to predict the speed and size of rate changes, there are ways to be prepared:

Step 1: Understand the relationship between interest rates and investments. Bonds and other fixed income securities can fall in value when rates rise. Preferred stocks, REITs (real estate investment trusts) and other income-producing investments can also be adversely affected. Certain economic sectors and stocks are more sensitive than others (e.g., utility stocks). Long-term bond investors, in particular, could see substantial losses in the market value of their bonds. Morningstar Research did a study and found that government bonds maturing in ten years could fall 10% in value for every 1% increase in interest rates.

 

Step 2: Review your current investments. Before making any moves, determine the sensitivity of your portfolio to interest rate increases. If you don’t know, get a 2nd opinion.

 

Step 3: Despite the risks (and not to contradict Step 1), the best strategy may be to do nothing. If you liquidate your current holdings, you could miss a bond recovery or a stock market surge. Moving into equities instead of bonds could be “jumping out of the frying pan and into the fire.” Economic bad news could easily send the stock market down 10% or more. Another terrorist attack or catastrophic event could send it much lower.

 

Step 4: Be clear about your goals. If you need to preserve principal, your primary choices will include: money market accounts, savings accounts and CDs (from the banks) and fixed and index annuities (backed by insurance companies). If you can accept risk (meaning you can tolerate fluctuations in the value of your investments and/or the loss of principal), your choices are much more broad: individual bonds, bond funds, preferred stocks, REITs, individual stocks, equity mutual funds, index funds and exchange-traded funds (ETFs).

 

Step 5: Build a diversified portfolio with a risk level you can accept. Bonds and other fixed income securities could still play a major role in achieving your financial goals. If liquidity is important to your situation, a diversified bond portfolio will probably make more sense than an annuity. Otherwise, fixed and index annuities may be good choices since they don’t lose value when rates go up. A combination of investments can help reduce overall risk and provide a hedge against the threats that could derail your financial plans.

 

Step 6: Consider the timing of your moves carefully. The Fed hasn’t raised rates. It has only said that it will stop buying bonds as the economy improves. Once the Fed stops buying, rates will likely rise further. Yields are rising on Treasury notes and bonds (our national debt). The Fed hasn’t raised the rates that affect what banks charge for lending and what they will pay for Certificates of Deposit (and they probably won’t for a long time). If you’ve got maturing CDs and cash, you may want to consider other options.

 

Step 7: Consider accelerating a house purchase. As ten-year treasury yields go up, so do mortgage rates. That can translate into higher monthly payments. Let’s say that you plan to buy a home for $200,000. You’ll pay the closing costs and 20% down with cash. The remaining $160,000 will be financed with a conventional 30-year mortgage. At a fixed rate of 4%, your principal and interest payments would be $764 a month. If you delay and mortgage rates have risen to 5%, your monthly payment would then be $859. The difference is $34,200 in additional interest over the life of the mortgage.

As our economy is weaned off historically low interest rates, the decisions and solutions to deal with the impact don’t have to be complicated. If you’ve never sought advice from a financial professional, now is the time.

 

 

David D. Holland, a CERTIFIED FINANCIAL PLANNER™ practitioner, hosts a weekday radio show at 9AM on AM1380 Ormond Beach, AM1230 New Smyrna Beach and AM1490 Deland. He has also authored two books in his Confessions of a Financial Planner series. Holland offers investment advice through Holland Advisory Services, Inc., a registered investment adviser in Ormond Beach. He can be contacted at (386) 671-7526. Email your financial questions to info@DavidHolland.com.