Rising Rates Affect More than Bonds
Retirees Especially Vulnerable
-----Interest rates are going up. Yields on U.S. treasuries just hit their highest level in over six months, even though the Fed hasn’t raised the overnight benchmark rate yet … though rate hikes are on the way, possibly as soon as September.
Rising interest rates are especially dangerous for retirees, who often have a large portion of their portfolio in fixed income securities like bonds. But rising interest rates mean danger for more than just bonds. Do you own any of the six asset classes below that are in the line of fire from rising rates?
1. Closed-End Funds (CEFs)
A lot of investors think closed end funds are pretty much like ETFs, but CEFs can actually do a lot of things ETFs can’t do—and some of those activities put them at risk when rates rise. Many CEFs use leverage. That means they borrow to buy assets, so their costs will go up as interest rates rise. That’s likely to make the fund somewhat less profitable, and investors may see their yields decline. How much leverage the fund takes on (as a percent of assets) and what kind of securities they use (fixed or floating rate, long or short duration) will also determine the effect of the rising rates. In addition, many CEFs invest primarily or entirely in fixed income assets. The value of existing bonds and other fixed income assets will fall as interest rates rise, so many CEFs will see their NAVs (net asset values) fall, which can negatively affect prices. How big an impact rising rates will have depends on what kind of fixed income instruments the fund owns, their yield, their duration ... everything down to how active the managers can be in reaction to rising rates. Not all CEFs will be hit by rate hikes. CEFs that invest in floating rate securities and equity CEFs that use covered calls to generate income are both good income-generating options that should be more resistant to rate-related selloffs.
2. Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts, or REITs, own real estate and pass along most of the income from the real estate (rents or mortgage payments) to shareholders. They can own any type of real estate, and many specialize in one type, like apartment buildings, malls, office buildings, self-storage facilities or hotels. A REIT that owns property directly and gets most of its income from its tenants’ rents is called an Equity REIT. A mortgage REIT, on the other hand, is a REIT that doesn’t own property directly. Instead, they own property mortgages and mortgage-backed securities. Their income comes from the interest they’re paid on the mortgages. They’re sometimes called mREITs. There are also hybrid REITs that own assets in both categories. All REITs are exempt from taxation at the trust level as long as they pay out at least 90% of their income to investors. That means they don’t retain much money to reinvest in their business, so REITs often borrow money to make new acquisitions or improve properties. When interest rates go up, REITs’ borrowing costs go up. Higher interest rates will also mean declining net asset values for mREITs, whose mostly fixed-rate mortgages will fall in price as mortgage rates rise. If you’re going to invest in REITs today, invest only in REITs with the highest credit quality (which will have less trouble securing new debt as rates rise) and minimal short-term debt maturities (so they don’t have to turn to the credit markets as soon). And avoid mREITs with a large proportion of fixed-rate mortgages.
Utilities have long been considered “widow and orphan stocks” for their slow, steady returns and low volatility. Utility companies usually operate legal monopolies in their market area, and don’t have to worry about losing customers. Long-term, utilities usually manage to achieve annual earnings and revenue growth in the mid-single digit range. This reliability makes utilities good dividend payers. They have predictable cash flows, so they can easily predict how much they’ll be able to afford in dividend payments. And they rarely cut their dividends during tough times, because utility demand is very stable. The average utility’s yield is good too, around 4% per year. However, utilities usually carry large amounts of debt because they rely on borrowing to maintain and improve their vast infrastructure. When interest rates go up, utilities’ borrowing costs also rise. That can mean lower profitability and slower dividend growth for investors. To get an idea of how your utility holdings might be affected by interest rates, look at the company’s short-term debt obligations (debt maturing in the next two years). Utilities with a lot of debt maturing in the near term will need to refinance at higher rates sooner, and may take a bigger hit in the market. You can also check the utility’s credit rating, which will indicate the utility’s ability to manage its current debt and secure future financing. Investment-grade-rated utilities (BBB-/Baa3) are generally safe, but that doesn’t mean they won’t take a temporary hit in the stock market due to investor fear of rate hikes.
4. Preferred Stocks
Preferred stocks are a special class of shares that are traded like stocks but actually represent unsecured debt, like a bond or loan. Preferred stock is issued at a par value, usually $25, and a specific coupon rate—often between 4% and 8%. Annual distributions will be equal to the par value times the coupon rate. For example, a company that wants to issue preferreds yielding about 8% would declare an annual dividend for the shares of $2 (because $2/$25 = 8%). Once the preferreds are trading, the annual dividend won’t change, so the yield may vary slightly. If the preferreds are trading at $26, then the current yield on the shares will be 7.69% ($2/$26 = 0.0769). Most preferreds issued at $25 will trade in a range between $23 and $27, depending on market conditions and investor sentiment about the company and the preferreds. As interest rates rise, companies will need to offer higher coupon rates on new preferred issues. That will make older, lower-yielding preferreds less attractive, and investors can expect to see their lower-yielding preferreds decline in value. Some preferreds have maturity dates when the company has to redeem the preferreds. If your preferred has a maturity date within your lifetime, you can at least be sure you’ll get the par value of the preferred back. This guarantee will also keep the preferred from losing as much value in the interim if rates spike. However, most preferred don’t have maturity dates, but call dates. On or after the call date, the company has the right to buy back the preferreds from investors at the par value, but not the obligation. Many preferreds are not called for years after their call dates, and a company is most likely to call its preferreds if interest rates have dropped and the company can now issue less-expensive debt. So having a call date is no guarantee that your preferred will retain value.
5 and 6. Bond Funds and Individual Bonds
Bonds have historically been recommended for investors who wanted to preserve their capital above all else. However, the low interest rates since the financial crisis have driven yields down across the board, so many bonds now yield barely enough to keep up with inflation. In general, the safer and shorter-duration a bond, the less it yields. Today, the safest Treasury bonds aren’t even yielding enough to cover inflation. These bonds will become toxic as rates rise, quickly losing value as investors and funds upgrade to higher-yielding new issues.
All bond prices are likely to decline sharply as interest rates rise. Standard bond funds will not be a good store of value, because they’re particularly susceptible to yield curve risk in a rising rate environment (they’re forced to regularly unload bonds at the shorter end of the yield curve while buying bonds at the longer end of the curve—for example, a bond ETF that tracks a three- to-seven-year bond index will constantly be selling bonds once they fall below three years to maturity and replacing them with bonds that don’t mature for seven years.)
If you’re going to hold bonds, be sure you are investing in them in a way that preserves your principal guarantee—which refers to the fact that, regardless of what happens to the bond price, you always get your principal back at the maturity date. For this to work, you have to hold individual bonds with a principal date you’ll be around for. If you’re holding a 30-year bond, you will be able to redeem it for full value in 30 years, but a lot can happen in the interim, including the bond losing much of its value for a time. If something unexpected happens, you or your heirs may be forced to sell it at a disadvantageous price.
The principal guarantee also only works if you buy the bond at or below face value. If you buy the bond for above-redemption value, you’ll lose some of your investment when you redeem it. (This might be worth it for the yield in the meantime; use one of the many online yield-to-maturity calculators to decide.)
If you decide to hold some of your portfolio in bonds, you can either buy individual bonds (I suggest bonds with maturities no further than 10 years out; you can also try laddering them), or a bond fund with a maturity date, like one of the Guggenheim BulletShares ETFs.