Retirees and near-retirees should strategize — not panic — over the specter of an interest rate hike in December and beyond, experts say.
Fixed income investments are on the front burner as investors contend with the possibility that the Federal Reserve may raise its key interest rate.
“Inflation is ticking up a little bit, and unemployment claims are back to their lowest levels dating to 1970, when the population was much lower,” said Robert Johnson, director of economic analysis at Morningstar.
“This suggests that some tightening is in order from the Fed, and in the next few meetings we’re likely to see a small rate increase,” he said.
It’s early in the game, but experts question whether these metrics, coupled with potential tax cuts and other stimulus programs from the incoming Donald Trump administration, could set the table for higher interest rates in the future.
Here’s what this might mean for your fixed income holdings.
Savings accounts and CDs
If the Fed raises interest rates in December by a quarter-point, don’t expect to see a major boost for savings accounts and new certificates of deposit.
But there may be a place for long-term CDs in your portfolio, especially if they have consumer-friendly withdrawal terms and low penalties.
“A CD with an easy withdrawal penalty gives you a put option — the right to sell it back to the bank — without incurring the loss of a bond,” said Allan S. Roth, founder of Wealth Logic in Colorado Springs, Colorado. He’s a proponent of using CDs, particularly those that are as long as five years, to protect against interest rate risk.
For retirees and pre-retirees, bond laddering — that is, buying a series of bonds that mature in different years — may help reduce interest rate risk.
With a ladder, you can reinvest the proceeds and interest as your bonds reach maturity. Or if you’re retired, you can use that money toward your cash flow.
You’ve also diversified your exposure to interest rates because you are buying bonds at a range of maturities, both shorter and longer term.
“Investors can ignore the impact of interest rate changes,” said Wade Pfau, professor of retirement income at The American College of Financial Services in Bryn Mawr, Pennsylvania.
Still, bond laddering is neither bulletproof nor cheap.
The difference between the bid and ask prices for an individual bond can be enormous, Roth said.
Finally, you still stand to lose money — albeit on paper — if rates rise. “You can convince yourself that you haven’t lost anything by holding the bond to the maturity,” Roth said. “Look up the value of the bond when rates rise, and you’ll see that it’s gone down.”
Fixed income checklist
Regardless of whether you ladder or you use a bond fund, now is agood time to understand what’s in your portfolio.
Carrie Turcotte, senior financial advisor at RiverCrest Wealth Advisors in Chattanooga,Tennessee, suggests the following steps for your fixed income review.
- Know the details of your holdings: What is the financial status of the company issuing your bond and the rating? You should know that investment-grade bonds are rated BBB or higher by Standard & Poor’s or a Baa by Moody’s. Be aware of the interest payment, and know whether you plan to hold to maturity.
- Understand your bond fund: Learn about the duration of your portfolio, its underlying contents and its risk profile. Duration is a measurement of a bond fund’s sensitivity to interest rates. The longer the duration, the greater fluctuation you’ll see in the fund’s price when rates change.
How is your manager approaching fixed income right now? “Don’t assume that strategic bond funds will be well-positioned for rising rates,” said Turcotte. “Right now, quality strategic bond funds are more concentrated in high-yield and floating-rate bonds.”
- Consider your quality-of-life goals: Watching fluctuations in your bond values will hurt. If you need to sit tight to meet your goals, don’t do anything drastic. “We don’t want to pull everything out of bonds or get people too excited about interest rate changes,” said Turcotte.
- Reconsider repositioning your cash: Keep some cash to insulate your income stream from equity market volatility or interest rate changes.