Finance How to protect yourself from rising rates Every change (financial or otherwise) brings both opportunities and risks; rising interest rates are no different. However, for retirees, it’s probably more important to talk about the risks of rising rates – wealth preservation being ultimately more important than wealth generation – and discuss how you might protect your portfolio from them. Re-examine your bond allocation Rising interest rates can wreak havoc on an investor’s fixed-income portfolio, particularly that portion of the portfolio which is invested in bonds, because the value of an existing bond typically falls when rates rise. Why? Because instead of buying an old bond at a low rate, investors can put their money into new bonds at a higher interest rate, and earn more. Basic economics tells us that when fewer people want something, the price of that “something” tends to fall. There are a number of ways in which to deal with this problem. Trimming back some or all of your bond portfolio is a simple solution. Shifting your bond allocation to shorter-term bonds (which tend to be less affected by rate increases) is another. You could also move some of your fixed-income allocation into variable or floating-rate investments – investments whose interest payments rise or fall in tandem with the central bank’s rate. If you’ve invested in bond mutual funds or ETFs, or if your advisor has constructed a bond ladder for you, it’s possible that your professional manager has already adjusted the portfolio in anticipation of rising rates. But you’ll want to doublecheck with your advisor, or with the websites of any mutual funds or ETFs in which you may be invested. Over the past several years, many investors put their money into long-term bonds because of their higher yields, without thinking of what might happen if rates rise. Depending on your circumstances, nowmay be the time to exit or trim back such positions, and emphasize safety of principal over yield. Take a close look at your REIT allocation It used to be that if you wanted income (as most retirees do), you invested in government bonds. But over the past decade or so, continued low interest rates have forced many retirees and other income-oriented investors to look elsewhere for yield. One of the most popular alternatives to government bonds has been real estate investment trusts (REITs) – diversified pools of office buildings, apartments, commercial property and other forms of real estate in which investors can invest via the stock exchange. These investments generate attractive income from the rents which they charge, while offering the potential for capital gains as the REIT adds more real estate to its portfolio. Some analysts expect REITs to fall in value over the next several years, as bonds offer higher rates – there’s simply less of a need to look for alternatives to bonds, so there will probably be less demand for REITs. Others expect REITs to revert to their traditional role in the portfolio, offering an attractive dividend yield, but not much in the way of capital appreciation. It’s a strong argument, given that a big part of the reason why many REITs rose in value was because they could borrow cheaply at low interest rates and acquire new properties – something that might not be so easy when rates move higher. Don’t take this the wrong way – there are still plenty of reasons why REITs might belong in your portfolio. But it’s probably a good idea to bring your allocation back in line with historic norms – now is probably not a time for overexposure to the sector. It may also make sense to take a pass on REITs with an aggressive acquisition strategy (a strategy that typically depends on low interest rates) and, instead, stick to high-quality names with an established history of dividend payments. Reduce (or refinance) debt As we discussed above, interest rates can have a dramatic effect on what it costs you to borrow money. If you’re currently a borrower, now is the time to take a full inventory of your debts and determine how any of themmay or may not be affected by rising rates. If you have “floating rate” debt – a variable rate mortgage or a home equity line of credit (HELOC) – the interest rate on your loan will fluctuate up and down in tandemwith the prime lending rate. If they rise too much, too soon, you could be forced to readjust your lifestyle just to keep up with interest payments. Bottom line: you shouldmake an effort to pay down as much as you can now, before rates rise significantly. If you have debt which you can’t realistically repay in a short time frame (your mortgage is likely the prime culprit here), it makes sense to take a look at refinancing instead. Talk to your bank or mortgage broker about locking in your loan(s) at current low rates, rather than waiting for rates to creep up. Such a move could end up saving you thousands of dollars in interest over the lifetime of the loan. Just make sure to run the numbers before you pull the trigger – there are times when the penalties and other costs of refinancing far outweigh any savings you may realize. Reduce exposure to highly leveraged business What we’ve said about your personal debt applies equally to the debt of businesses. In the months and years to come, any business with a high debt load will feel the burden of additional interest payments, and those payments will be a headwind for their profitability. This is not to say that they’re bad companies in and of themselves. But their stock performance will likely lag other stocks which don’t have that additional burden. There are some industries in which debt is constantly needed to fund expansion and continued operation. Telecom companies and utilities are prime examples here, as are many resource companies that need money to explore and develop new resource properties (mines, oil fields, processing plants, etc.). Such investments don’t always do well in times of rising rates. In other cases, there will be company-specific issues that have more to do with the decisions of management than challenges which the entire sector is facing. For example, company ABC may have taken on a big chunk of debt several years ago to acquire a competitor. Or company XYZ may have an average level of debt, but they’ll likely have to refinance it all in two years, at which time analysts expect rates to be higher. Neither of these is a big problem when interest rates are low. But if rates rise quickly, they may be an issue. 30 | www.snowbirds.org
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