Should You Fear Higher Interest Rates?

NEW YORK (TheStreet) -- How should you allocate your investments when interest rates appear to be heading higher?

The answer in large part depends on your investment horizon. If you are in for the very long term, fluctuation of interest rates may not be very important for your strategy. But over the next couple of years, rising rates may have quite an effect on stock and bond valuations.

Despite the well-publicized rise in long-term interest rates during 2013, as the Federal Reserve prepared to begin tapering its bond purchases, rates are still at low historical levels. The market yield on 10-year U.S. Treasury bonds was 2.65% on Thursday. That's down from 3.04% at the end of last year, but up from 1.89% a year ago. But long-term rates are still expected to head higher, since the Fed plans to end its bond purchases by the end of 2014.

The yield on 5-year Treasury bonds was 1.49% Thursday, down from 1.75% at the end of 2013, but up from 0.77% a year ago.

Meanwhile, the Federal Reserve continues to keep its target short-term federal funds rate in a range of zero to 0.25%, meaning that savers are really taking it on the chin, with banks paying next to nothing on savings accounts and paying very low rates on CDs. The national average interest rate for a 12-month CD is 0.20%, according to BankingMyWay, while a 24-month CD pays 0.38% and a 60-month CD pays 0.78%, on average.

So the most conservative savers, with no risk tolerance, are earning very little.

The S&P 500 closed at record high of 1,854.29 Thursday, although the index has risen only slightly this year, following a 30% gain in 2012 and a 13% return during 2011.

In the face of an expected rise in interest rates, many investors may be wondering how they should allocate their retirement savings accounts. Managers of 401k plans tend to recommend diversification, with investments spread over asset classes and stock investments spread over various industries and locations.

Wells Fargo (WFC) manages a group of Advantage Dow Jones Target mutual funds. Each fund is designed for investors seeking to retire at a particular time, with the idea being that the fund's allocation will become more conservative -- that is, more income-oriented -- over time.

For example, the Wells Fargo Advantage Dow Jones Target 2035 Fund is designed for investors planning to work for another 21 years, or thereabouts. The fund's assets are roughly 50% weighted to domestic stocks, 25% in foreign stocks, with the remaining 25% mostly invested in bonds and other income-paying securities.

The fund's stock holdings are spread across various industries, with Financial Services, Technology, Industrials and Consumer Cyclical stocks carrying the greatest weight.

At this stage of the bull market, some investors might fear that the expected rise in interest rates may cause a stock market decline, and may also be nervous about the decline in bond prices always brought about when long-term interest rates rise. All things being equal, prices of bonds go down when interest rates rise, because new bonds are being issued at higher rates. Bonds with similar ratings will see their market prices adjust in such a way to make their current yields match the yields of newly issued bonds.

FM Global Senior Vice President of Investments Paul LaFleche in an interview earlier this week discussed his team's investment philosophy and expectations for rising interest rates, and the possible effect on market performance.

FM Global is a mutually owned property and casualty insurer, primarily focused on insuring commercial property.

All insurance companies manage investment portfolios, trying to achieve solid returns in order to increase their likelihood of making profits even when insurance losses are high.

"We have a very strong asset level of $13 billion, with a surplus level of about $9.5 billion, with annual premiums approximately $5 billion," LaFleche said.

"We have always had a large equity exposure, of roughly 50%, enabled by a very strong balance sheet. The typical competitor has far less [in equity investments], around 20%, and some are all fixed income."

Looking ahead, LaFleche expects rates to rise moderately, near-term:

"Our feeling over the next year is for the rate on 5-year Treasury bonds to go up 50 to 75 basis points. If that happens with a bond duration of about five years, our bond returns will be slightly positive, losing 2.5% on principal, but we would collect our coupons and make small money."

LaFleche also pointed out that the downside faced by bond-holders under the above rising-rate scenario, "is not a huge risk when compared to the potential downside of equities."

A bond portfolio's duration is its average number of years to maturity. Generally speaking, the shorter the duration, the less price volatility for the portfolio as interest rates rise and fall. Shorter duration portfolios also tend to have lower yields than longer duration portfolios.

Under LaFleche's expected scenario, there isn't much risk for bond holders over the next year, especially when considering the interest payments coming in.

What about stock prices when interest rates rise moderately?

"We are going into a more normal [economic] environment and earnings are still good, so stocks can offset the losses from rising rates with earnings growth and [price-to-earnings] multiple support from a more normal bond/stock valuation tradeoff," LaFleche said.

But he doesn't expect investors to see the type of bull market for equities this year that they saw last year.

"I think earnings growth will continue in an upper single-digit rate, but I don't think multiples can continue to rise at last year's rate. So we are expecting upper single-digits returns for stocks.," LaFleche said.

So for investors managing diversified portfolios, LaFleche doesn't see much to fear from rising interest rates, at least over the next year.

Very long-term investors seeking to maximize returns over the long haul need to consider their own level of risk tolerance.

Do you check your 401K account balance each day? Or are you content to let the market play out, with the knowledge that when stock and bond prices decline, your current investments are going in at lower prices?

If you have decades until your expected retirement, patience and diversification are probably best, and the Wells Fargo Advantage Dow Jones Target Fund described above provides food for thought.

If you are getting close to retirement, the standard advice is to move toward an income-oriented portfolio. This means bonds, preferred stocks and common stocks with strong dividend yields.

And if you're just starting out and beginning to fund a retirement account, take advantage of what's out there. Does your employer provide matching 401k contributions? If your employer matches contributions up to 3% of your salary, for example, then you will make an immediate 100% return on each contribution. That's a hefty return in any market.

Then, call the plan administrator and speak to a retirement services representative. They can help you make prudent investment choices, depending on how long you plan to continue working and how much market risk you can tolerate.

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-- Written by Philip van Doorn in Jupiter, Fla., and Antoine Gara in New York.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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