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The Federal Reserve just raised interest rates again and continues to take an assertive stand against historically high inflation numbers.
What’s that doing to your investment portfolio?
“Interest rates are critical inputs to the valuation process—and influence the value of stocks and bonds,” says Robert R. Johnson, Professor at the Heider College of Business at Creighton University in Charlottesville, Virginia. “Warren Buffett has been quoted as saying, ‘Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.’ The effect of the near zero interest rates was to inflate the value of stocks because of the reduced incentive to hold risk-free government debt. As we see rates rise, we will see the attractiveness of government debt increase and the returns to stocks and other risk assets lowered. Second, rate hikes increase a firm’s cost of capital, and, all else equal, lower the profitability of businesses because firms pay a higher interest expense. Third, many investors use margin—borrowed money—to buy stocks and other assets. An increase in interest rates lessens the appeal of borrowing on margin. Fourth, there is a simple substitution effect that accompanies an interest rate increase as the attractiveness of newly issued securities (with higher promised payments) rises relative to the desirability of other securities.”
If you’re retired or about to retire, the Fed’s rapid departure from quantitative easing to hawkish aggression has taken its toll on your financial situation precisely when you most desire stability and reliability in returns.
“Rising interest rates can have a detrimental effect on retirement savings investments, as they can make it more difficult for investors to generate returns,” says Tommy Gallagher, an ex-investment banker and the Founder of Top Mobile Banks who lives in Berne, Switzerland and Ann Arbor, Michigan. “When interest rates go up, it means that investors have to pay more for their investments, and it can be harder to make a profit from them. This can have a negative effect on retirement savings, as the returns may not be as high as they once were.”
Most retirees harvest their retirement savings once they retire. This means they’ll use the income or sell some assets to pay for retirement expenses. Rising interest rates, coupled with record-high inflation, represent a double-edged sword.
“If retirees withdraw money from a stock and/or bond portfolio for needed income (taking dividends, interest, and selling off some principal), they will need to sell more principal assets at their lower prices to maintain the income amount that was received before the rise in interest rates,” says Mark D. Kinsella of Family Financial Planning Services in Wheaton, Illinois. “If interest rates are rising, prices in the retail and wholesale domains may be rising. Thus, to enable their income to keep up with price increases, retirees may have to sell off even more assets to receive the income that is needed to maintain a livelihood. Over time this could be devastating to the investment portfolio.”
If you continue to keep your retirement savings in a 401(k) plan, or if you invest in mutual funds that contain bonds (including balanced funds and target date funds), your portfolio has experienced the blunt force of rising interest rates.
“For those with 401(k)s, which include mutual funds that invest in bonds, it is likely that interest rate hikes will negatively affect their share prices and, ultimately, the net value of the asset,” says Richard Gardner, CEO of Modulus in Scottsdale, Arizona.
The news, however, isn’t all bad.
“A rise in interest rates is likely to result in a decline in the share price and net asset value of any mutual funds you have in your 401(k) plan that invest in bonds,” says Steven Holmes, Senior Investment Advisor at iCASH based out of Toronto, Canada. “On the other hand, as these funds add new holdings paying higher rates to their portfolios, their income is likely to increase over time.”
If you’d like to stay in the fixed-income asset class, the safest strategy you can follow may be to limit your investments to individual bonds and ladder that portfolio.
“For bonds—what most retirees spend their time thinking about—it’s actually rather simple,” says Rubin Miller, Chief Investment Officer at Perspective Wealth Partners in Austin, Texas. “If you are investing in investment grade bonds (as primarily you likely should be to avoid default risk), then the best rule of thumb is that your duration needs to be shorter than your investment horizon. This will give you ample time to recoup any paper losses in prices as the funds you own have old bonds maturing to buy new higher yielding bonds or enough time for the individual bonds you own to mature, and you can run this process yourself.”
If you’re fortunate enough not to have to sell assets to maintain a comfortable retirement, the impact of rising rates, at least as it pertains to your portfolio, becomes less relevant.
“For retirees not taking income from stock and bond investments, as interest rates rise, the values of stocks and bonds in the portfolio will decline, and, on the surface, this would hurt,” says Kinsella. “However, if the assets are not sold in order to provide money for the owner, there will not be any harm to the investor/owner.”
Rising interest rates also affect real estate, whether you hold it for personal use or as an investment.
“The biggest risk of increased interest rates is that it makes it more expensive to borrow money,” says Alex Byder, owner of BD Home Holdings, LLC in Lafayette, Indiana. “If you have a variable rate mortgage, for example, then you are at risk of paying a much higher mortgage payment.”
From an investment standpoint, rising interest rates might limit the ability to draw revenue from real estate holdings. In addition, higher mortgage rates pose a challenge when trying to sell a property. This applies to seniors seeking to move to a smaller home.
“When people have a good retirement portfolio, the only area that can hurt retirees could be in their real estate portfolio because fewer people may be able to buy real estate with higher interest rates,” says Omer Reiner, President of FL Cash Home Buyers, LLC in Ft. Lauderdale, Florida. “Many people have reported that retirees may have a harder time downsizing, but if they sell their house and have a good retirement fund, they should be able to downsize using cash alone.”
While rising interest rates impact investments, the impact is not the same on all investments. It makes sense to understand the differences and to invest accordingly.
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