Ambiguity is the signature of the Federal Reserve. The Federal Reserve, which controls the nation’s interest rates, was expected to announce changes to short-term interest rates last week. The Federal Reserve, or the Fed, did indeed make an announcement, though it was ambiguous to say the least. It was decided that short-term interest rates would remain the same until further discussion in October and November. At which point the Fed could vote to increase interest rates, the first increase in ten years, or the interest rates could remain the same. Either way, understanding interest rates, the role of the Fed, and the possibility of increasing interest rates are all necessary for successful investment and portfolio management.
The first part in understanding interest rates comes through the awareness of the function of the Federal Reserve. The Federal Reserve is an independent entity that adheres to congressional oversight. The Fed was created “to promote sustainable growth, high levels of employment, stability of prices, to help preserve the purchasing power of the dollar and moderate long-term interest rates.” Traditionally, or at least for the last ten years, the Fed has kept interest rates low to encourage economic growth by making corporate and consumer borrowing easier. Yet, current trends show that the Fed will gradually raise interest rates, which will slow down the economy, ultimately making borrowing more difficult. This represents a paradigm shift from the extraordinary stimulus and fiscal policies that the markets and investors who have grown used to. So how can investors actively manage their portfolios in view of this paradigm shift?
The answer lies first in fixed income. Long term investments in fixed income are more sensitive to changes in interest rates. In other words, the longer the term of the investment in a higher rate environment, the greater risk there is of a low return. One way to combat this is through the use of shorter investments when trends indicate that interest rates will rise. Yet, no matter how high interest rates rise, this is not a signal to move from centering one’s portfolio around fixed income. Fixed income is appropriate in a diversified portfolio and should remain a core component due to its potential for income and capital preservation.
There are ways to diversify a portfolio’s fixed income rate that are appropriate in a rising interest rate environment. Floating rate notes adjust based on movements in short-term rates, while fixed rate bonds do not as readily adjust. Senior loans, likewise, are beneficial in an environment typically supportive of credit. Convertible securities are hybrids that offer the growth benefit of equities and the stability of fixed income. Lastly, high yield bonds can provide protection in an environment with a strong economy and healthy corporate balance sheets.
The fixed income rate side of one’s portfolio is extremely important, but equity exposure is also of great significance. Investors should focus on industries that traditionally benefit from rising interest rates. The financial sector has historically benefited from rising interest rates as banks are more willing to lend during improved economic conditions.
While current trends suggest that higher interest rates are forthcoming, the Fed has voted to keep interest rates at its current state until more data can be gathered. The timeline for higher interest rates may be ambiguous, but it is inevitable to happen. As the economy shifts, so must one’s approach to a portfolio. While immediate sweeping changes to one’s portfolio are not necessary, awareness of fixed income portfolio diversity through floating rate notes, senior loans, and convertible securities as well as portfolio equity exposure will allow an investor to be prepared to ride the tide of rising interest rates.