Rising Interest Rates - Impact on Your Portfolio
By Rainier Group Investment Advisory, LLC

With the recession of 2001-2002 behind us and the economy finally showing some signs of life, the Federal Reserve has started to increase interest rates. Alan Greenspan and Co. get enormous amounts of press, but what do increasing interest rates really mean to your portfolio and why? While no two economic periods are ever exactly the same, we can draw some definitive conclusions from past interest rate cycles and modern financial theory.

From an Equity Viewpoint

Rising interest rates (all else being equal) are quite negative. This negativity is derived from three different sources: 1) bonds and stocks are competing assets, 2) higher rates will slow the economy down, and 3) interest expense will increase for corporations.

• Competing Assets - As interest rates rise, bonds look more and more attractive to potential bond investors. At higher rates, money starts to flow into fixed income investments and out of the stock market, which will put downward pressure on stock prices. As rational investors, we are going to choose the highest possible return given a certain level of risk. If a U.S. Government bond (risk-free investment) is yielding 8% and we think the stock market might increase 9% (with uncertainty, volatility, and risk), we would definitely forego the stock investment and buy the bond. This will put instant downward pressure on the stock market.
• Economics - As interest rates rise, the economy will slow down. The consumer will delay or entirely put off big ticket expenditures such as houses, boats, vacations, etc. (A $300,000 mortgage at 5.5% equates to a monthly payment of $1,700. But at a rate of 7% the payment increases to $2,000 monthly). Corporations making capital budgeting decisions face the same dilemma. Some buildings won’t get built, factories won’t add capacity, and companies won’t hire as many new employees, all simply because the financing costs of such projects have increased. This vicious cycle translates into lower corporate sales, smaller profits, and lower stock prices.
• Capital Structure - Virtually all Fortune 500 corporations are funded partly with debt instruments. As their bonds mature, they usually have to issue new bonds to pay off the old. When interest rates are rising, these new bonds will be issued with higher coupons resulting in higher interest expense, lowering net profit margins, which will inevitably hurt stock prices. In this respect, individuals will be affected as well. Adjustable rate mortgages have become more and more popular over the past few years. While these instruments seem wonderful when rates are falling or sitting near 40 year lows, they will hurt many people when rates start to increase.

The three points above mean the stock market will automatically fall in the near term as interest rates increase? Not necessarily.

So far there have been three rate hikes, raising the Federal Funds discount rate from 1.00% to 1.75%, which is still more than accommodative for economic growth. For reference, before 9/11 the discount rate sat above 3%. Throughout the 1990’s the rate averaged 5%. In 1981 the discount rate was above 19%! At this point, if there is any sustained pause in economic growth, it would be tough to blame the impact of “high rates”.

The usual reason the Fed increases interest rates is to slow down the economy and fend off inflation (taking away the punch bowl at the party). At this point, there is no discussion by the Fed about an “over-heating economy” nor are there any major inflation worries. The Fed is simply taking away the emergency rate cuts, which were needed after 9/11, and getting us back to a more normal level.

Further, the Fed’s actions have been completely predictable (they told us they are going to raise rates at a “slow and measured pace”) which has given the equity market time to digest the information and act accordingly. The thing Wall Street hates the most…surprises. There is evidence the Fed is confident they have good control over the economy as a whole. They are only increasing rates by 0.25% at a time and doing so at their scheduled meetings. This is unlike 2000 and 2001 when the Fed cut rates from 6.50% to 3.75% in ten months (all before 9/11).

From a Bondholder’s Viewpoint

As interest rates rise, bonds lose value. This rather simple inverse relationship is made more complicated with many variables that comprise bond investments. The degree of principal loss is determined by many competing factors, but the main two are: 1) the maturity of the bond, and 2) the coupon rate attached.

Maturity

• Long-term Bonds (with a fixed coupon) will react the most. In the above example, a person holding a 20-year bond when rates increased from 5% to 7% takes a 21% loss on their principal. The reason is that the owner will have to sit for 20 years before they can re-invest their principal at the higher rates. This is a very unfortunate circumstance; given fixed income securities are usually implemented in a portfolio to offset the risk in the stock market.
• Short-term bonds (with a fixed coupon) will react the least. In the above example, a person holding a 1-year bond only loses 2% in current market value when rates increase from 5% to 7%. After the bond matures in 1 year, the investor can re-invest 100% of their principal in a 7% bond and enjoy the benefits of higher interest payments.
• Floating rate investments are insulated from rising rates as the rate earned by investors is adjusted periodically. These investments yield less than their non-floating brethren with the difference between the two being the price an investor pays for the benefit of the adjustment. These are particularly good investments in an increasing interest rate environment.

Coupon

The other factor impacting current bond prices is the coupon rate (the stated interest rate paid on the bond from issue until maturity). All else being equal, a bond with a lower coupon will have greater price volatility. A _% increase in the Fed Funds rate has a greater proportional impact on a 3% coupon bond than on a 5% coupon bond, thus causing a greater loss of “market value” in the lower coupon bond.

From a bondholder’s perspective, when interest rates are perceived to be in an increasing environment, we want to hold the shortest maturity possible (or adjustable rate paper) in order to preserve principal.

Conclusion

While there are very few certainties in investing, it is safe to say rising interest rates are considered a “negative” for both stock and bond markets. This presumes however that we are operating in a normal market.

Given the past three years of economic and geo-political turmoil we have faced (9/11, significant business recession, and the stock market bubble collapse), this has been anything other than a “normal marketplace”. The Federal Reserve has taken interest rates to the lowest levels in 40+ years and the current posture of increasing rates to achieve a more neutral stance should not adversely impact the stock market until rates exceed a 3.5% to 4% level.

However, the bond market will still face the time-tested problems of principal loss on bonds as rates increase. Thus, we at the Rainier Group will continue to advocate the shortest bond maturities possible (and also adjustable rate holdings) as a means to preserve our client’s principal values. When rates have reached their high point, we will begin to reposition our bond holdings into longer maturity holdings.

It is imperative that we manage the ebb and flow of the Federal Reserve’s Monetary Policy and adjust our client’s portfolios accordingly, taking into account the overall posture of the current business cycle, inflation outlook and other factors likely to impact the stock market. Our thoughts on portfolio structure for the near term will be found in the “Tactical Consideration” commentary section within your quarterly report.