Investing in a higher interest rate environment
While this is bad news for borrowers, it is good news for many investors, especially those who need to live off the income their investments generate.
The last five years have been tough for self-funded retirees in particular, who have been forced to move into more risky investments, as interest on term deposits and cash have fallen to record-low levels.
Rising rates are also good news for investors because they typically mean that the economy is growing, unemployment is falling, and corporate profits are expected to increase, so the central bank is seeking to stop the economy from overheating.
So, in the context of all this good news, what should investors do?
Review your investments
It’s always a good idea to periodically review your investments and financial goals, but in the current environment, it’s worth doing that sooner rather than later. The shift towards rising inflation and interest rates following years of super-loose monetary policy is a significant economic change that warrants a review of your investment strategy.
Investments to consider when rates are rising
Floating rate bonds
Another strategy to reduce risk is to invest in inflation-adjusted bond funds. A floating rate exchange-traded bond fund may be worth considering for investors who want to put a piece of their portfolio — say, one to three years' worth of retirement income — into a less volatile investment that keeps up with current inflation. A floating-rate bond (also known as a floating rate note or FRN) is a debt security that pays a regular coupon (interest) that varies over time. The interest received is determined by a set margin above the 3-month bank bill swap rate. There are floating-rate bond fund ETFs on the Australian Securities Exchange that are secured against bonds issued by major Australian banks.
Residential Mortgage-backed Securities (RMBS) are bonds secured against the mortgages of hundreds or even thousands of Australian property owners. Firstmac’s High Livez fund gives ordinary investors access to these securities, which pay regular monthly income and are usually accessible only to major institutional investors. High Livez RMBS investments are all floating-rate assets, which receive a fixed margin over the one-month bank bill rate. This means that in the event of inflation and rising interest rates, the funds’ distribution returns will also rise. For more information about High Livez, see here.
If you still want a fixed-income component to your portfolio but don’t want floating rate bonds, you can consider term deposits. As rates rise, these will start to offer higher interest rates than they have in recent years. If rates rise after you have locked into a term deposit, you will not receive the benefit of the new higher rate, but unlike a bond your capital will not be reduced. The bank will still repay your money in full at the end of the deposit period. To reduce the risk of lost income, it’s a good idea to avoid longer duration term deposits when rates are rising.
Equities comprise the majority of most peoples investment portfolios, and there is no reason why that would change in a rising interest rate environment. As stated above, rising interest rates generally mean that the economy is going well, and that is good news for listed company profits. Below are some sectors and types of companies that have historically done better than average in times of rising interest rates.
The financial sector
Financial stocks generally benefit from a growing economy and higher interest rates since banks can charge borrowers more, while still offering modest interest rates on deposit accounts that supply much of their funding. Other financial stocks to consider are insurance companies, which take your insurance premiums and invest them in low-risk assets, knowing that at some point they will probably have to pay some of it out to policyholders. Obviously, the higher the return they get on those low-risk assets, usually government bonds, the more profit they will make, which is good for their dividends and share price.
Well capitalised firms
One group of companies that may not do well when interest rates rise is highly-indebted firms with low earnings. They will have to pay more to finance their debts, which will hurt profits (if they make any). To protect your portfolio, it may be a good idea to consider highly profitable, well-capitalised firms. Historically, these have performed best when financial conditions tighten. The performance of stocks with 'quality' attributes such as high return on capital, strong balance sheets, and low price volatility is positively correlated with tighter financial conditions.
It is tempting to assume that a wise move when rates are likely to rise would be to lock in a low, fixed-rate on your mortgage. The problem with this strategy is that your lender is not stupid and will also be keenly aware that rates are likely to rise, and their cost of funding will also be increasing. This means that the fixed rates they offer will probably already incorporate the likelihood of future rate rises (i.e. their fixed rates will be higher than the current variable rate). Over many decades in Australia, it has been shown that choosing a variable interest rate is the lowest-cost long-term borrowing strategy. Depending on your circumstances, fixing your home-loan interest rate can be a great idea but it is really a form of financial insurance, rather than a long-term money-saving strategy. If you can afford to make repayments at the current fixed rate, but couldn’t afford to make your repayments without great hardship if the variable rate went up significantly, then now is the time to consider paying a slight premium to fix your rate.
Continue investing and diversifying your funds
Even with rising interest rates, you don't want money to languish in your bank account uninvested. Instead, keep investing and diversifying your assets. As always, make sure you understand any assets you are seriously considering buying, and get independent financial advice before you make any investments. You can protect your money against inflation and interest rate increases with a properly diversified portfolio that grows over time.