Some long-term investments at risk if rates rise

In theory, an upswing in interest rates from their historic, post-recession lows should be a good thing for people saving for retirement.
Yet that might not be the case for everyone and after decades of falling rates, certain trusted investment vehicles may become less advantageous than they have been.
“It’s good that yields on short-term, safe investments will be going from zero to something positive,” said Robert E. Cusack, portfolio manager at WhaleRock Point Partners LLC in Providence. “It’s not good for longer-dated, fixed-income investments, which will fall in value, some substantially. The change in the direction of interest rates is prompting a re-evaluation of investment strategy from the largest public pension plans to the smallest 401(k) accounts of individual participants.”
Particularly vulnerable to rising rates are long-term bonds, which fall in price as interest rates rise and potential buyers can get higher yields from new bonds.
For 30 years, as interest rates have declined, investors have gobbled up bonds, including long-term bonds, and posted solid returns with less risk than the stock market.
However, with effective interest rates near or, at their lowest, below zero for so long, Cusack said it’s almost inevitable that future bonds will carry higher rates and be worth more.
That outcome would be bad for bond mutual funds, which have had a significant presence in retirement portfolios that now appears to be shrinking.
In late September, Boston-based Fidelity Investments announced that it would reduce the allocation of bonds in its target-date retirement funds and increase the share of equities.
“Now it’s clear that with investors withdrawing tens of billions of dollars of capital from bond mutual funds since May, individuals and institutions alike have gotten the message that the world has changed, and bonds are more a source of risk and real losses than safety,” Cusack said. So what should investors with an eye on retirement do to replace the safety and returns they may have been getting from bonds?
Matt Blank, director of investments at Washington Trust Wealth Management in Westerly, agrees that we’ve seen the bottom of interest rates and bond yields, but said that doesn’t mean short-term rates are going to rise enough for investors to jump into money markets.
“Short-term rates aren’t going anywhere for awhile and you don’t want your money to be idle and produce no returns,” Blank said. “It’s probably at least into the middle of 2015 where you will have a de minimis return on any money-market funds.”
Blank said retirement investors should be wary of bonds with durations of more than 10 years.
To the traditional asset allocation of 60 percent stocks to 40 percent bonds, Blank said it would probably make sense to move toward a 65-to-35 ratio. “I wouldn’t go out beyond 10 to 15 years maximum for fixed income,” Blank said. “We think the economy is fairly healthy, so some interest-rate exposure is OK through floating-rate debt, so there is some increase in yield as rates move higher.”
At the start of October, the yield on the 10-year U.S. Treasury note was about 2.6 percent and Blank said he wouldn’t be surprised to see it rise to 3.5 percent by the end of 2014.
“With rates falling as fast they have, I would agree that the bull market in bonds is over,” said Dan LeGault, senior financial adviser at StrategicPoint Investment Advisors in Providence. “It’s only a matter of time before rates rise, although it becomes less clear as to how fast they’ll rise. They’ve tended to follow 10-to-30-year cycles.” Legault said his firm isn’t directing clients out of fixed-income investments, but making sure they diversify within fixed income to reduce rate-sensitive risk. That means bonds with three-to-five-year time horizons and floating-rate bank loans. The latter provide protection against interest rates climbing, but trade that for higher default risk.
Rising interest rates have also spurred demand for dividend-producing stocks.
Looking to the future, Legault said returning to more typical interest rates should generally be a positive for investors and the economy as long as they are stable.
The dramatic spike in rates this past spring, which came in response to comments about an end to bond purchases by the Federal Reserve Board of Governors, is an example, Legault said, of the kind of volatility that can trip up retirement investments.
“If it is a smooth ride up, if we can get the normalization, there are positives,” Legault said. “CD rates are more positive, there are ancillary insurance-rate benefits and you are getting better return on fixed income, even while you are getting less value.”
Cusack at Whalerock said while investors don’t need to necessarily jump to one asset type or another, they should keep a close eye on what fund managers are doing to make sure they aren’t taking on too much risk in search of yield.
“Beyond getting the asset allocation and fund selection right, investors must monitor the funds they own closely,” Cusack said. “It’s clear from our work that even mutual funds with the best reputations must be monitored closely in the post-crisis world. Managers can stray from their mandates, and investors need to know they’re getting what they signed up for.” •

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