They say interest rates are set to go higher this year. Up is a good thing in financial markets, right? Not necessarily.
Remember that when interest rates rise, the prices of traditional bonds fall. So if you own a bond that is paying a 3% interest rate (in other words, yielding 3%) and rates rise, that 3% yield doesn’t look as attractive. It’s lost some appeal, and more precisely and practically, it’s lost value in the marketplace.
But why expect higher rates in 2014? Partially because the Fed is taking its foot off the economic stimulus accelerator, says Russ Koesterich, BlackRock’s Global Chief Investment Strategist. He points out that, after years of purchasing massive amounts of Treasury and mortgage bonds (a process known as quantitative easing), the central bank is slowly reducing (or “tapering”) the scale of those purchases. And with the Fed buying less, he explains, there’s less support to keep bond prices high.
Couple that with another eventuality: an increase in the federal funds rate, which has been held near zero since late 2008. Jeffrey Rosenberg, Chief Investment Strategist for Fixed Income, says the Fed is working hard to be transparent and to avoid surprises in this regard. The central bank does not want its transition to higher rates to upset financial markets. Mr. Rosenberg warns, however, that “such an outcome is not at all guaranteed—just look at what happened last year at the first utterance of ‘taper.’”
SO WHAT’S AN INVESTOR TO DO?
An environment of higher yields is good reason to rethink your bond strategy. “Some areas of the bond market,” Mr. Rosenberg explains, “are more vulnerable to rising rates than others.”
“We expect more upward movement in yields of shorter-duration Treasuries, so that’s one area to approach with caution.” Mr. Rosenberg also expects that rates are likely to be volatile, “one of the reasons we prefer flexible or unconstrained bond strategies that can move quickly as market conditions change.”
Still Opportunity in Stocks
Rising rates are somewhat of a mixed bag for stocks. “In one sense, rising interest rates are a negative for equities since higher rates make it more expensive for companies to borrow money,” Mr. Koesterich says. But rising rates are also associated with economic strength, and that’s generally good for stocks.
In the current environment, Mr. Koesterich believes the positives outweigh the negatives. “Reasonable valuations, decent corporate earnings, low inflation and a still-improving economy all support the case for stocks over the long term.”
Ultimately, after 30 years of falling rates, the likely path now is upward. The best course for investors, Mr. Rosenberg says, is to be aware of the impact and prepare your portfolio now for the outcome.