Fed Rate Hike Is Nothing to Panic About - TheStreet

NEW YORK (MainStreet) – Federal Reserve Chair Janet Yellen sees waning economic headwinds, which means your investment strategy might need some upgrading before a potential rate hike.

"Delaying action to tighten monetary policy until employment and inflation are already back to our objectives would risk overheating the economy," she said in May. "For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy."

Financial advisors have been preparing clients for this inevitability for roughly two years. Yet they still find themselves talking clients down and adjusting their strategies to shield them from the more detrimental effects of a rate hike, while preparing them to adapt to a new climbing rate environment.

“Interest rates have been abnormally low for the last several years, and increasing rates can be viewed as a positive sign that the market is returning to a more normal state,” says Benjamin Sullivan, Certified Financial Planner and portfolio manager with Palisades Hudson Financial Group in Scarsdale, N.Y. “The Fed will continue to have its foot on the gas pedal for the foreseeable future, since they plan to only gradually increase interest rates from zero. Just because the Fed is raising interest rates doesn’t mean that it will be a drag on the economy if rates are still low in absolute terms.”

The last time the U.S. economy saw a rising rate environment was when the federal funds rate climbed from 1% in May 2004 to 5.25% in August 2006. It plateaued there until June of 2007, when the housing crisis, subsequent bank failures and economic collapse sent them plummeting for the next two years. At the outset, a rising rate makes rock-solid bonds suddenly fallible.

“What it means in the short term is that investors ought to temper themselves for a change in sentiment around bonds and fixed income investing,” says John Diehl, senior vice president of strategic markets at Hartford Funds. “If we are indeed nearing the era of rising rates, it will mark the end of one of the most impressive positive market runs for fixed income investing in history. Therefore, we should adjust our expectation that yes, fixed income securities can lose money."

Not just a little, either. Dan Yu, managing principal with EisnerAmper, notes that for each 1% interest rate rise, the average bond duration of three, four or five years loses 3%. That loss only happens if hist client has to sell the bonds early before they reach maturity, but those clients have no such worries at the the current rate. As the Fed has flirted with rate hikes, Yu says he has kept investors prepared by addressing the short term first.

“For the past two or three years, what we've done for clients with fixed-income exposure who are much older and need a much more diversified and conservative portfolio is take their municipal bond portfolios and ladder them out,” Yu says. “They're holding individual pieces of paper with maturities between one to 12 years in anticipation of this rate hike, with the duration kept to a modest two to two and a half years.”

Volatility in bonds and other fixed-income investments typically isn't as stocks, which react poorly to surprises and tend to handle gradual changes like a rate adjustment with more grace. However, simply adjusting to the fact that fixed income investments can lose value takes time. For the longer term, diversifying one's investment portfolio and considering bonds' role in that new reality is a good first step.

“For some, we may have stretched in duration or quality to generate cash flow,” Diehl says. “If you fit in the latter category, remember, there is no free lunch. Greater risk is associated with greater potential returns, but there is a reason that it is called risk. A rising rate environment will make that clear.”

Diehl suggests diversifying within the fixed-income portion of your portfolio just to minimize any potential repercussions of a rate hike. If you are retiring in the near future, however, and don't want to wait and see how this plays out, Yu from EisnerAmper suggests creating layers of protection for yourself and your assets. He suggests having a six- to 12-month cushion for expenses held in a high-yield money market account and backing it up with a laddered bond portfolio that has different bonds coming due each year.

With that in place, investors wouldn't have to sell assets just to fund their post-retirement lifestyle. The best part is that, if rates don't rise and investors end up not needing the money, they can buy another bond at a higher rate when the rate finally rises.

”Investors who have positioned their fixed-income portfolios for a rising interest rate environment (by holding cash, short-term bond funds, and floating rate bond funds) should welcome interest rate hikes, since they will finally earn a decent income on their investments,” says Sullivan from Palisades Hudson.

Even if you aren't imminently retiring, it's important to remember that a rate hike isn't the end of the world. Markets have been historically cyclical and are creatures of feast and famine. Also, chances are fairly good that if you've lived through one rate hike, you stand a better chance of knowing how to handle the next one.

“It may be informative to inquire about other periods in history which might reflect similarities to today’s market environment so that we might at least gain insight as to what may occur from here, acknowledging that no cycles are identical,” Diehl says. “Like Mark Twain was purported to say, 'History may not repeat itself, but it certainly rhymes.'”

This article is commentary by an independent contributor. At the time of publication, the author held TK positions in the stocks mentioned.