Investing In Volatile Markets: Funds For Rising Interest Rates

Interest rates have a significant impact on investment strategies. When rates are cut, it can lead to faster economic growth and a bullish stock market. On the other hand, when interest rates rise, it becomes crucial for investors to adjust their portfolios to mitigate risks and maximise returns. Here are some investment options to consider when interest rates are on the rise:

- Short-term and medium-term bonds: These are less sensitive to rate increases than longer-term bonds. While they may provide lower returns compared to long-term bonds, they can help reduce volatility in an investment portfolio.

- Floating-rate debt: Pairing short-term bonds with floating-rate debt, such as bank loans, can be a strategic move as their adjustable interest rates are less sensitive to rising rates.

- Treasury Inflation-Protected Securities (TIPS): TIPS are adjusted based on the US Consumer Price Index (CPI) and can offer protection against inflation, making them attractive during periods of rising interest rates.

- Stocks in specific sectors: The financial, consumer discretionary, industrials, and retail sectors tend to benefit from higher interest rates. Within the financial sector, banks, insurance companies, and brokerage firms often see improved profit margins. In the consumer discretionary sector, manufacturers and retailers of appliances, cars, clothing, and home improvement goods can benefit from increased consumer spending.

- Real estate investment trusts (REITs): While rising interest rates can cool down the real estate market, investing in REITs can provide diversification and exposure to the real estate sector without the challenges of directly managing properties.

- High-yield savings accounts: In a rising interest rate environment, these accounts can offer competitive returns with relatively low risk, especially if rates run above inflation.

- Long-term certificates of deposit (CDs): CDs can offer higher interest rates than savings accounts, and locking into a CD during a period of falling rates can help investors take advantage of higher returns for an extended period.

- Long-term corporate bond funds: These funds can provide higher returns than government or municipal bond funds, making them attractive for investors seeking higher cash flow while reducing overall portfolio risk.

Invest in banks and brokerage firms

Banks and brokerage firms are a good investment option when interest rates rise. These financial institutions earn money from the interest they charge on loans and credit. When rates are higher, credit is less readily available, and consumers have to pay more to borrow. This means that banks and brokerages can earn more from interest income and see improved operating profit margins.

Banks can also make money from interest when rates are low, as borrowers tend to have more money in their pockets and often borrow more. Even when rates are low, banks remain profitable due to the fees, commissions, and service charges they collect.

However, it is important to note that regional and national banks may not benefit from higher interest rates to the same extent as brokers, asset managers, and insurance companies. Banks have more limited options when it comes to what they are allowed to invest in, and their profits may be squeezed when rates are lower.

When considering investing in banks, look for those with diversified and wide-ranging business lines, such as JPMorgan Chase or Goldman Sachs. These banks have a robust presence in the U.S. and worldwide, offering a range of services that can help them navigate changing interest rate environments.

Brokerage firms, such as Charles Schwab, also tend to see an uptick in trading activity when the economy improves and can benefit from increased interest income. A healthy economy often leads to more investment activity, which can result in higher profits for brokerage firms.

Additionally, insurance stocks can flourish as interest rates rise. The relationship between interest rates and insurance companies is linear, meaning their growth is directly proportional to the interest rate. Insurers with steady cash flows are compelled to hold safe debt instruments, such as bonds, to back the policies they write. As interest rates rise, the returns on these bonds increase, leading to higher growth for insurance companies.

When investing in banks and brokerage firms during a rising interest rate environment, it is essential to consider the overall economic conditions and the health of the financial sector. Interest rates are just one factor influencing stock market performance, and a diversified investment strategy that takes into account various economic indicators is generally recommended.

Invest in cash-rich companies

When interest rates rise, investors can benefit from investing in cash-rich companies. These are companies with large cash reserves, which earn more on these reserves when interest rates are higher.

Large, mature companies that have significant cash holdings are a good option for investors. For example, Apple had $28.4 billion in cash at the end of its second fiscal quarter of 2023. A company like Apple can afford to hold large amounts of cash, whereas a smaller, less mature business that hoards cash may be a riskier investment as it may indicate that the company is not reinvesting in its own growth.

Investors can also look for companies with low debt-to-equity (D/E) ratios or large amounts of cash.

Buy when rates are low

When interest rates are low, investors may be tempted to reduce their allocation to bonds and put more of their money into stocks to chase higher returns. However, doing so could put your portfolio at a higher risk level than dictated by a well-designed investment plan. Here are some strategies to consider when interest rates are low:

Diversify your fixed-income portfolio

Adding more stocks may not be a practical response for older investors who depend on bonds for stability and income. Instead, consider replacing some investment-grade bonds with high-yield or emerging market options. Corporate bonds of lower credit quality offer higher payouts due to the increased risk. Emerging market bonds can also offer higher payouts. Municipal bonds are another good option, as the income from these is not taxed.

Increase your equity allocation

Increasing the amount of money you invest in stocks makes sense in a low-interest environment since equities are likely to generate higher returns. However, it is vital to keep your risk tolerance and investment time horizon in mind. Younger investors can afford to have a much larger percentage of their portfolio in equities.

Invest in real assets

Real assets include commodities, precious metals, and other tangible assets. They can add extra diversification to a portfolio since their correlation to stocks and bonds can be low. They can also offer a potential hedge against inflation. While investing in real assets may sound daunting, it is easier than ever thanks to mutual funds, exchange-traded funds (ETFs), and real estate investment trusts (REITs).

Take advantage of low-interest rates to borrow and reinvest

For investors with a longer time horizon and greater appetite for risk, a low-interest rate environment offers a good opportunity to make use of that margin account. Experienced investors might borrow money at a low rate and invest it in higher-yielding securities. However, borrowing money to buy investments is always a risky proposition, as leverage amplifies returns and losses.

Beware of inflation hedges

Tangible assets, such as gold and other precious metals, tend to do well when rates are low and inflation is high. However, investments that hedge against inflation tend to perform poorly when interest rates begin to rise, as rising rates curb inflation.

Invest in technology and healthcare

When interest rates rise, investors need to adjust their portfolios to protect their investments and generate profits. Technology and healthcare companies are a good bet during such times.

Companies in these sectors tend to reinvest their profits in growth opportunities instead of paying out dividends. This innovation leads to outsized performance over other sectors of the economy. Historical data shows that these industries yield higher average gains during periods of rising interest rates than the rest of the S&P 500 index.

Mature companies in the technology and healthcare sectors tend to retain more profits as they reinvest in growth opportunities rather than pay dividends. As a result, they can be an excellent choice for investors seeking long-term growth with interest rates in mind.

Embrace short-term or floating-rate bonds

When interest rates rise, bond prices fall. This is because when interest rates rise, new bonds are issued with higher yields than older fixed-income securities. As a result, investors tend to purchase these new bonds to take advantage of the higher yields, causing the value of the older bonds to decrease.

Long-term bonds are more sensitive to interest rate changes than short-term bonds. This is because there is a greater probability that interest rates will rise within a longer time period than a shorter one. Therefore, investors who buy long-term bonds and then attempt to sell them before maturity may face a deeply discounted market price.

Short-term bonds are easier to hold until maturity, thereby alleviating the investor's concern about the effect of interest rate-driven changes in the price of bonds. Short-term bonds are also less affected by interest rate changes because they have a shorter duration. Duration measures the sensitivity of a bond's price to changes in interest rates. For example, a bond with a duration of 2.0 years will decrease by 2% for every 1% increase in rates.

Floating-rate bonds are another option for investors looking to reduce their exposure to interest rate changes. Floating-rate corporate bonds have interest payments that increase when Treasury rates rise, resulting in almost no exposure to changes in Treasury rates. Additionally, because floating-rate securities generally have short maturities, changes in credit spreads have a limited impact on their value.

However, it is important to note that reducing exposure to both interest rate changes and credit risk simultaneously may not be the best strategy. This is because sometimes these two factors move in opposite directions. For example, interest rates may rise because the economy is improving, while at the same time, credit spreads are tightening.

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