Interest Rates: What Goes Down May (Eventually) Come Up

Why It Matters:

• After years of low interest, the Federal Reserve Board has been raising rates.

• Different types of investments react differently to interest rate increases.

Chase Squires tkc.profilePicture Written by: Chase Squires | Transamerica
May 18, 2017

5 Min readClock Icon

With your savings account earning close to nothing in interest, it’s hard to believe there was a time – possibly in your lifetime, back in 1981 – when even a lowly, no-risk, 6-month certificate of deposit (CD) was paying back almost 18%.

While few are predicting a return to those days, interest rates have started to get off the floor. Investors may be wondering what this could mean.

After the 1981 watermark, federal funds interest rate set by the Federal Reserve Board (the Fed) embarked on a gradual drift lower. There were some spikes – nothing approaching the 1981 peak rate of more than 19% – and then came the Great Recession.

As home prices tumbled and the U.S. economy sputtered, the federal funds rate fell during the next couple of years from just over 5% to pretty near zero. Savings account interest payments and interest on new CDs slumped with the rate cuts.

Income investors (those who want their investments to return real money they can spend now rather than seeking pure growth) may be looking at their next steps.

The Fed has twice raised interest rates since the November election. And some online banks are offering more than 1% interest on savings. Yield on 10-year Treasury bond (money that is leant to the government in exchange for interest payments) crept up from a record low of 1.375% in July 2016 to something closer to 2.6% in March of 2017.

Transamerica Senior Investment Analyst Kane Cotton, CFA®, reviewed this year’s prospects with an eye toward investment classes that may benefit from or protect against rising interest rates. He came up with a few things to keep in mind in a rising rate environment.

• Riding the tide. Short-duration bonds (basically short-term loans you may make to a government or a company) can deliver returns that are less sensitive to changes in interest rates than longer dated bonds. You can even “float” up or down with interest rates with something called a “floating rate” fund. These funds are made up of bonds that make coupon payments which rise and fall with market interest rates such as the London Interbank Offered Rate (LIBOR).  While they do carry credit risk, this floating rate feature typically means less sensitivity to changes in market interest rates.

• Getting “real.” Seeking a real or “inflation-adjusted” return can lower correlation to the market. U.S. Treasury inflation-protected securities (called “TIPS”) periodically adjust their principal for inflation with the intention of allowing an investor’s returns to outpace inflation over time.

• Being active. Actively managed, multi-sector funds with flexible mandates may be able to shift allocations to sectors that, unlike U.S. Treasuries, are less correlated to interest rates. They can also pursue opportunities to earn higher yields.

• Getting credit. Consider taking on some credit risk in place of interest rate risk by looking at investments with a yield that’s better than U.S. Treasury's. Consider credit such as investment grade or high yield corporate bonds.

• Going global. When U.S. rates rise, foreign markets may offer attractive opportunities, relatively speaking. Interest rate cycles can differ by country and region. Look at corporate and government debt opportunities in overseas markets to seek returns and diversify risk in rising rate environments.

Looking ahead, Transamerica Asset Management Chief Investment Officer Tom Wald, CFA®, sees the potential for at lest two more interest rate increases from the Fed in 2017. Wald says income investors may want to keep an eye on interest rate risk and focus attention on short-term bonds, floating rate notes, preferred stocks, high-yield bonds, and high-dividend stocks.

Wald believes a combination of these asset classes could help investors mitigate overall interest rate risk while achieving yield in what is still a low rate environment by historical standards.

And since nobody can predict the future, Wald suggests seeking the help of an expert who can help you decide what course of action is best for your individual situation.

“In a potentially rising interest rate environment that may include more risk, we believe it makes sense to take advantage of the expertise and capabilities of a seasoned portfolio manager who understands the implications of the new rate cycle we cold be entering,” Wald said. 

Things to Consider:

We’ve been through a long period of very low interest rates. Remember to consider how a series of interest rate increases may affect your current and future investments.

If you’re seeking investment income, look at a variety of investment classes. Some may fare better than others.

Interest rate increases in the U.S. may affect overseas investments differently. Opportunities outside the U.S. may be available.

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