24 July 2019

Invest Like it’s 1979

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If you lived through the 1970s, one of your greatest sources of astonishment is probably that interest rates aren't soaring. In that carbuncle of a decade, you counted yourself fortunate if you got a mortgage at 12%, and cursed your money fund if it paid less than 10%. Nowadays, you worry that interest rates are going to rise, and soon, and rapidly.

But with interest rates somewhere in the fifth sub-level of the financial world's parking garage, it's a good bet that sooner or later, interest rates will rise. The question is how to position your portfolio for higher interest rates, if, in fact, you should.

You can divide interest rates into two parts. Short-term interest rates are largely controlled by the Federal Reserve. Its key fed funds rate is between zero and 0.25%. The Fed has said that it will probably not raise short-term rates until next year, depending on the outlook for the economy and inflation.

Long-term interest rates are largely controlled by the bond market, although the Fed has intervened heavily there as well. Its program of purchasing long-term bonds and mortgage-backed securities should end by October. But even as the Fed has tapered its bond-buying program, rates have fallen. The benchmark 10-year Treasury note yield ended 2013 at 3.03% and closed Thursday at 2.33%.

Sooner or later, however, interest rates will rise. You'll notice two immediate effects: 

• When the Fed raises interest rates, you'll get better yields on money market funds and bank CDs.

• You'll get higher yields but lower prices on your bond funds. Bond prices fall when interest rates rise, and your higher yields won't be enough to offset your fund's share price.

You can get some idea of how badly your fund will get hit by a figure called duration, which most funds supply in their literature. A fund with a duration of 3.5 years will fall 3.5% for every percentage point rise in interest rates.

Stocks, however, don't necessarily fall when interest rates rise. Rising rates mean a greater demand for loans, which is an indicator of a growing economy. Typically, the stock market initially views the start of a Fed interest rate increase positively — a token that things are headed back to normal after a recession. It's not until the Fed has hiked rates repeatedly that the stock market starts to get uneasy — the origin of a once-useful rule called "Three steps and a stumble." The rule says that after the Fed has raised its discount rates three times, stocks fall.

How should you prepare for a rise in rates? If you want to reduce interest-rate risk for your bond funds, consider a CD ladder instead. You start by dividing the money you'd normally keep in a bond fund into five CDs, each of which matures one year later than the next. When the one-year CD matures, roll it into a five-year CD. You'll do this until you're continually rolling over five-year CDs. You'll continually lock into the highest current CD rates without losing principal, assuming you don't incur any early-withdrawal penalties.

If you're a stock investor, your biggest fear should be a period of rising inflation and rising interest rates — in which case, both stocks and bonds will let you down. What can you do?

• Increase the percentage of your portfolio devoted to money funds. Your yield will rise as the Fed raises rates.

• Look for a high-quality, short-term bond fund.

• Consider adding a fund that invests in Treasury Inflation-Protected Securities (TIPS. TIPS' principal rises alongside the consumer price index.

You might also consider adding a 5% position in gold as insurance against inflation. The easiest way to own gold is through a mutual fund. If you're a long-term investor, though, your best protection against a period of high interest rates and high inflation is time.

Click here to access the full article on USA Today.

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