This past December the Federal Reserve announced they will be increasing the federal funds interest rate by 0.25% to 1.50%. The good news is fundamentals seem to be stable enough that the Federal Reserve continues to tighten monetary policy. This gives the economy a vote of confidence. In the media, we often hear about rising interest rates and their impact on the economy, but some of you might be asking “How does this impact my portfolio?”
Increased Borrowing Cost
As a Lexington Wealth client, one way you may be impacted is if you have a margin loan balance on your account(s). LWM has negotiated a very favorable margin rate equal to the federal funds rate + 0.50%. This means that when the Fed raises rates, your interest rate increases. As a result, you will be paying more interest on your margin balance. If you have a margin loan, it is worth evaluating paying it off completely or faster due to the higher borrowing cost.
Impact on Bonds
Another potential impact on your portfolio could be a shift in your bond allocation. When interest rates rise, the price and value of your existing bonds may decrease, lowering your overall fixed income allocation.
This is because most bonds are issued at a fixed interest rates based on market rates at the time of issuance. When market rates rise above the fixed rate of your current bonds, there could be less demand for your lower yielding fixed income. Therefore, to sell these lower yielding bonds, you may need to accept a lower price. There is typically an inverse relationship between bond prices and interest rates as illustrated here.
Impact on Stocks
An indirect impact to your portfolio could be a shift in your stock allocation. A significant portion of your equity allocation is comprised of stocks from companies looking to grow their businesses. One way companies grow is to borrow money to fund projects. If interest rates are higher, it will likely cost companies more to take on new debt. This could have a negative impact on equity prices on a macro level. Not only could higher rates increase costs and decrease profits, but they can also lower companies’ incentives to invest in new projects if the cost/benefit is too high.
You might be thinking, “If both stocks and bonds could be negatively impacted by rising rates, what should I do?” We believe the answer is to be well diversified. Not all bonds react the same to rising rates. For example, floating rate bank loans are typically short-term bonds issued with variable or adjustable rates that tied to a market rate like LIBOR or the 3-month Treasury rate. Since these bonds are short-term and the rates are not fixed, when they mature they are typically reissued at higher rates. Therefore, when rates rise, investors could be impacted for a short time, but then benefit from higher rates as they reset. The same goes for equities as asset classes are impacted differently. For instance, a higher federal funds rate could impact US based companies as they typically borrow money in US dollars from US lenders. International Central Banks such as the ECB, BOE and BOJ are still keeping rates historically low which is beneficial for international companies looking to borrow money in their local currencies.
Investing 101 teaches us how markets should behave, but they rarely react in-line with the text book. After all, investors – emotional/irrational individuals – impact the markets. It is important to note that markets are generally efficient, and the rate increase may have already been “priced into the market.” It is also worth recognizing that the Federal Reserve only controls short-term interest rates. The market determines longer-term rates. Therefore, one should not assume that all rates will rise or that all bond prices will decrease. For example, despite recent federal funds rate increases, long-term interest rates have not risen.
Our conclusion is to be well diversified in both your fixed income and equity allocations to possibly reduce the impact that rising interest rates have on your portfolio.
Please reach out to your LWM Team if you would like to discuss this, or anything else.