U.S. Markets closed

Rate Hike Worries? Look Beyond the Usual Suspects

Christine Benz

Stocks tumbled Friday and again Tuesday on concerns that the Federal Reserve could move to increase short-term interest rates sooner rather than later. Bonds fell sharply, too: For example, Vanguard Long-Term Treasury (VUSTX), which invests in long-duration bonds issued by the U.S. Treasury, has lost nearly 4% over the one-week period through Tuesday; the typical long-term government-bond fund, which has a little more leeway to invest in other types of government bonds besides Treasuries, has lost about 3% during the past week. (This tool lets you see in real time what the futures markets are expecting the Fed to do.)

The pattern of U.S. government bonds suffering when interest-rate worries are running high is a familiar one. Because the market considers government bonds to be devoid of credit risk, there aren't a lot of moving parts; their prices tend to be a direct reflection of investors' interest-rate expectations. If investors are operating under the assumption that there will be new government bonds issued with higher yields attached to them, that has an immediate negative impact on the prices of already existing bonds with lower yields attached to them. The opposite is also true: When the economy shows signs of weakness and investors are expecting that interest rates could trend down (or at least remain flat), demand for government bonds--and in turn their prices--tends to jump the most.

Yet even as long-term Treasuries are widely--and rightly--called out as the key investments to be careful of in an interest-rate uptick, other types of securities have the potential to feel a tremor, too. As yields have been depressed across the board, valuations have risen, and the duration on the Barclays Aggregate Index has extended to more than 5 years, investors should be aware of the potential for rate-related volatility in other pockets of their portfolio, too. Here are some spots to keep an eye on; while few are expecting rates to begin moving up with a vengeance, investors may have to put up with some price fluctuations in the months and years ahead.

Junk Bonds
Investors widely assume that very high-quality corporate bonds will react negatively to interest-rate hikes, but junk bonds are often considered to be less vulnerable. There are a few key reasons for this. First, lower-quality bonds typically perform well in periods of economic strength, as investors become more sanguine about the ability of highly indebted companies to make good on their obligations; that's usually the same time the Fed is considering interest-rate hikes to head off higher inflation. Additionally, high-yield bonds are often considered less vulnerable to rate hikes because their yields are higher in absolute terms, so price declines have a less meaningful impact on their performance than is the case with lower-yielding high-quality bonds. A 0.25% change in short-term rates will be likely have a bigger impact on the price of a bond yielding 2% than it will on the one yielding 6%.

Yet thanks to strong performance, high-yield bonds don't have as much of a yield buffer as they once did. Owing to a fairly steady stream of good news about the economy and perhaps more important, a dearth of decently yielding alternatives, investors have been gravitating to high-yield bonds, pushing up their prices and taking yields down in the process. The average high-yield fund has gained 6.5% on an annualized basis over the past five years, the third best of any taxable bond category. While the yield differential--or spread--between high-yield and U.S. Treasuries spiked to more than 8 percentage points this year, it has dropped to just 5 percentage points recently.

That means that high-yield bonds are threading a fine needle. If rates go up, junk bonds might come under price pressure as investors would prefer to own higher-quality credits as higher yields come online. Moreover, senior analyst Eric Jacobson notes that higher interest rates can create headwinds for highly leveraged businesses.

"Most high-yield issuance is comparatively short (that is, new bonds usually issue at 10 years) and is frequently done under the pretense that it will be refinanced or retired ahead of time when conditions favor it. So if rates rise, even if they don't affect borrowing costs immediately, the likelihood that they will increases. That can cause problems for highly leveraged borrowers if the market believes the rate hikes will succeed in slowing growth and thus imperiling those borrowers' future health," he said. On the other hand, if the economy softens--and economic data aren't universally strong, which is one reason the Fed hasn't yet moved aggressively to raise rates--the default rate for high-yield bonds could go up.

That's not to say that you shouldn't own high-yield to serve as an aggressive complement to your high-quality fixed-income portfolio, but check your existing exposures first; portfolios with plenty of equity exposure probably don't need high-yield exposure. Also plan to have a nice long time horizon of 10 years or more.

Treasury Inflation-Protected Securities
No one has ever suggested that Treasury Inflation-Protected Securities would hold up well in times of rate increases. Holders of TIPS bonds get an adjustment in their principal values to reflect increases in the Consumer Price Index, but when CPI is on the move, interest rates often are, too. In times of economic strength, TIPS bonds have the potential to give with one hand (by delivering an inflationary adjustment) and take away with the other (by falling in price amid rate changes). This article takes a closer look at why investors shouldn't confuse TIPS' inflation protection with interest-rate protection.

Yet investors might be surprised at just how rate-sensitive TIPS bonds actually are. The Barclays Aggregate U.S. Treasury Inflation-Protected Securities Index, along with most core-type TIPS funds, has a duration (a measure of interest-rate sensitivity) of 8 years or more, longer than the Barclays Aggregate Index, which has a duration of about 5 years today. Add in the fact that TIPS yields, as is the case with nearly every other bond type, have slunk lower, meaning they'll provide less of a buffer against price declines than was the case in the past. (This research paper discusses this phenomenon in detail.)

As with high-yield bonds, this is not to suggest that investors should shun TIPS bonds from their portfolios; in fact, I consider them even more central than junk bonds, especially for retirees. But it does point to the virtue of carefully considering your time horizon when deciding what type of TIPS product to buy. If you have a shorter time horizon of, say, seven or fewer years, you may well be better off in a shorter-term TIPS fund like Vanguard Short-Term Inflation Protected Securities (VTIPX). If your time horizon is longer, a longer-duration, core-type TIPS fund is fine, because it's apt to compensate for its higher volatility with higher returns over a longer holding period.

High-Yielding Stocks
As bond yields have declined, investors have increasingly been using dividend-paying stocks in lieu of bonds. Many high-quality dividend payers currently feature yields that are higher than high-quality bonds'; indeed, the current yield on the S&P 500 (~2.2%) is higher than that of the Barclays Aggregate Bond Index (1.8%). Moreover, stocks have more leeway for capital appreciation than bonds, albeit with more downside potential.

In terms of interest-rate sensitivity, a feather in the cap of dividends is that the amount of dividends a company pays out is determined by its board; current market yields may play a role, but corporate strategy and capital-allocation considerations are more important. By contrast, the yield a company must pay on its bonds is largely determined by the marketplace and prevailing yields at time of issuance. Thus, bonds tend to be more directly affected by rising rates than dividend-paying stocks. Additionally, because higher interest rates are typically the product of strong economic environments, stocks may in fact behave reasonably well amid periods of rising interest rates; specific industries, such as banks, may actually benefit.

You can expect to see stocks that investors have been using for mainly for current income in lieu of bonds, however, to struggle in a rising-rate environment. On the short list: Utilities, REITs, and higher-yielding consumer-staples and pharmaceutical names. That's because many investors buy them for their yields more than expectations about future growth or capital appreciation; when there’s a potential for higher-yielding bonds to hit the market, high-dividend-paying stocks tend to look less appealing. Retirees, in particular, don't need to run away from such high-yielders, especially if they provide a component of their living expenses, but they should be aware that short-term volatility could be bracing.