- The Federal Reserve plans to begin a series of interest rate hikes starting in March.
- Check your portfolio for longer-dated bonds, which tend to fall more in price when rates go up.
- Higher interest rates tend to hurt fast-growing stocks, which may currently occupy a big chunk of your portfolio.
By now, you've likely heard that the Federal Reserve plans to embark on a series of interest-rate hikes this year, beginning in March.
For borrowers, the effect of rising rates is straightforward: Money is about to get more expensive. For example, credit cards, which come with variable rates tied to the short-term rate set by the Fed, will charge you more for carrying a balance over the coming months if and when the rate hikes occur.
Rates on mortgages are expected to rise as well.
But higher interest rates can affect your finances, even if you're not paying anyone back at the moment. That's because, depending on the types of investments you hold, movements in interest rates can have a direct and an indirect impact on the value of your portfolio.
"The panic of the day is the news about interest rates," Brad McMilan, chief investment officer at Commonwealth Financial Network, wrote in a recent note. The fear he sees in financial media is "that higher rates are going to derail the economy and the markets, in that order."
He and other financial experts aren't necessarily buying that narrative, but they still recommend you check in on your portfolio to examine your holdings' sensitivity to movements in rates. Here's what they say to look out for.
Bonds and interest rates have a direct relationship. When new bonds are issued, most pay a fixed interest rate known as the coupon rate. A bond with a 2% coupon and a face value of $1,000, for instance, will pay you $20 per year for the life of the bond.
After they're issued, bonds sell on the secondary market, and that's where fluctuations in rates come into play. Say rates go up, and now new, similar bonds are paying 3%. No one is going to pay the full $1,000 face value to buy your bond at 2% anymore, so you may have to sell it at a discount to make up for the difference in yield.
For this reason, bond prices and interest rates move in opposite directions.
How dramatically the price will drop in response to a rise in rates is measured in a bond's "duration." The higher the duration, the more a bond's price will drop after a rate hike. Duration typically corresponds to a bond's maturity — essentially, how far away the bond is from paying the owner back the principal.
With rates on the rise, longer-dated bonds are in the most danger of falling in price.
Video by Stephen Parkhurst
What does that mean for investors now? "As rates drift higher, it won't be good for bond prices — especially bond mutual funds," says Mike Stritch, chief investment officer at BMO Wealth Management. "One element for folks to consider is that it's likely more attractive to be on the short end of the fixed income spectrum."
In other words, if you hold bond funds, check their average duration, available on the fund's website or on mutual fund data sites such as Morningstar. The longer the duration, the more the bond portion of your portfolio may be hurt by rising rates.
Stock investors don't particularly like rising rates either.
Higher interest rates mean it costs more for financial institutions to borrow. When it becomes more expensive for banks, they in turn make it more expensive for their customers. That includes both businesses and consumers, which acts as a sort of double whammy for stocks.
Firms themselves have rising costs to fund the business they want to do, and their customers, who now have to pay more the likes of mortgages and credit cards, have less disposable income to buy the goods and services that businesses sell.
Fast-growing companies that rely more on borrowing than older, established, cash-rich firms do tend to struggle in rising-rate environments, says Stritch. "Interest rate rises, particularly abrupt interest rate rises are prone to negatively impacting some subsets of the marketplace," he says.
"Those tend to be the more speculative, high growth names. It may make you wonder, if you've had a big run in your technology and growth names, if it's time to abandon ship."
Video by Stephen Parkhurst
Some investors have certainly thought so. In anticipation of rising rates, many investors dumped their faster-growing tech names earlier this year, leading to a pullback in tech stocks and a rout in riskier assets such as meme stocks and cryptocurrency.
That doesn't mean it's time to make any wholesale changes to your investing strategy, says Stritch, though it may be time to rebalance if years of gains have your portfolio looking lopsided. "It's been so growth-centric since the start of the pandemic. We're now looking for ways to balance that out," he says.
"If folks did a deep dive on their portfolio, they may find a lot of tech bias because that's where the winners have been. They may want to take a look at that."
If you find that your portfolio is overly tilted toward growth-oriented tech firms, now may be a good time to rebalance to your target allocation by adding some dividend-paying value stocks, for instance, he says.
But don't leave your tech stocks for dead. The sector is "not worth abandoning altogether," he says. "[The need to boost] productivity is a tailwind for tech that is going to last far into the future. You may want some more quality exposure, but you want to maintain growth and tech exposure."
Investing involves risk, including the loss of principal. This material has been distributed for informational purposes only and may not apply to all investors or investor portfolios. Carefully consider your investment objective, risk tolerance, and time horizon prior to effecting material changes to your portfolio or asset allocation.
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