How Will Higher Interest Rates Impact my Portfolio? (Part 2)

A few of our clients have requested that we expand on our June post about rising rates. In particular, they’ve asked: “why not switch entirely to bonds with shorter maturity, in order to better protect against rising rates?”  We see multiple reasons for not doing so:

• We have no more faith in our ability to time the bond market than we do in our ability to time the stock market. If you had asked us in 2009 where short-term interest rates would be in 2015, we would not have guessed that they would still be near zero.  Moreover, the timing and magnitude of a rate increase matter a lot: as the chart below shows, the negative price impact from an increase in rates can be rapidly offset by the income received.
  
  This example (extrapolated from numbers from the Vanguard Group) shows the impact of rising rates on an intermediate bond fund, when including the income received during the period.Note that a 2% increase in rates would trigger about an 8% loss for the fund shareholders after 1 year. However, it would take only 3 years for the same fund’s total return (including income) to break even. Even a 5% increase in rates would take less than 5 years for shareholders to recover their original investment. In other words, if your timing is off, or the magnitude of the rate increase is smaller than anticipated, it doesn’t take much for the timing strategy to yield lower results than a simple buy and hold. When you add transaction costs and potential tax consequences, it bolsters the case for long-term investors to stay the course or make only marginal adjustments, which has been our strategy.
• We anticipate relatively small increases in short-term rates in the next 12 months, i.e. a cumulative rise of 1% or lower. Moreover, a rise in short-term rates doesn’t necessarily mean that longer-term rates will follow suit.  5-year rates, which have a more direct impact on the bond fund in our prior example, might go up less or even not move at all.
• Bonds and bond funds tend to reduce, not increase, the downside risk of a balanced portfolio over the long-term. In doing so, they create a ballast that is particularly important to people living off of their portfolio. As illustrated during the recent financial crisis (2007-2008), higher quality, longer maturity bond funds were one of the only asset classes which performed well in a severe market downturn.

As long as we don’t anticipate a major rate increase over a multi-year period, we believe that our current strategy of making incremental changes over time will serve our clients well. We also feel that investors will eventually benefit from higher short-term rates, as the income received from CDs, money markets, and other savings accounts will finally increase. For the past few years, these saving vehicles have not generated enough income to offset the impact of inflation, a development that has hurt long-term investors and particularly those who were conservative with their investments. (For those of you interested in reading more research on this subject, the Vanguard Group published an excellent paper in 2013 available here.)

Strategies to extend savings in retirement
Finally, we wanted to highlight a New York Times article that does a good job of summarizing options that are available to retirees who are moderately short on their savings goals, yet still plan on retiring. Some of these recommendations have no downside (i.e. maximizing social security benefits, lowering taxes) and should be implemented by every investor; others represent trade-offs (annuities, downsizing) that should only be considered by people who have a higher risk of outliving their assets. Nonetheless, it is somewhat comforting to know that there are mitigating options in such situation besides working longer (up to a point). We always encourage clients to review their situation with us before making a final decision on when to retire.