It has been a long time since we had something that resembles normal interest rates and normal economics. Some even called the financial environment we live in as the “New Normal”. Retirees and savers have suffered the most during this prolonged low rate period. Retirees could not generate reasonable income from their investments without going further out on the risk scale and savers and accumulators could not benefit from the stability of bonds with at least a return that places them ahead of inflation and taxes.
Low interest rates are part of the interest and economic cycles. Prolonged periods of low rates, similar to what we have been witnessing for over a decade, are not common. Now that the central bankers around the globe are embarking on tightening policies and rate increases the investors are facing new questions like what is the bond outlook for 2018 and is it time to invest in bonds ahead of rate increases? The answers to these two questions depend on many variables like how high will rates go? What is the time horizon and the risk propensity of each individual investor, what are the alternative components of the investor’s portfolio and how do they work together in such a way to reduce risk and finally what are the individual investor’s objectives? These are variables that should be taken into consideration when advisors are putting together a strategy to build any type of portfolio for clients.
Advisors should prepare for an unusual frequency and magnitude of interest rate increases and an end to, or at least a slowdown, in quantitative easing through contraction of balance sheets by central bankers around the globe. The wounds of the 2008 financial crisis have not healed in the central bankers’ minds. They are still nervous and would like to avoid derailing the economic recovery that has been slow coming. At the same time, the Federal Reserve will be watching the impact of the fiscal stimulus that may result from the tax reform and the pending infrastructure spending. If the Fed thinks the stimulus will cause the economy to overheat or if inflation, which is now benign, starts to rise at a significant rate it will speed up the interest rate increases both in frequency and size.
The rising interest rate environment can be detrimental to the bond components of portfolios. Bond investors tend to be long-term oriented seeking income with preservation of capital. Both objectives are hard to achieve in a low rate environment on the rise that in turn causes principal erosion. Many advisors erroneously shift into bond funds expecting higher yields and stability. Unfortunately, most bond funds carry long-term bonds that tend to suffer the most when rates rise. As such long-term investors are caught in a short-term spiral.
Long-term investors cannot afford to lose capital in the short run. We therefore suggest advisors consider short to intermediate term fixed income ETFs on temporary basis that they can eventually replace with longer-term ETFs, individual bonds or even bond funds after the dust has settled, the premium wiped out and possibly purchase them at a discount.
