It’s been nearly three years since the Federal Reserve began unwinding its zero-interest-rate policy by raising the federal funds rate (the interest rate U.S. banks charge other banks on overnight loans, which helps dictate short-term interest rates for the rest of us). Since then, the Fed has raised the federal funds rate more than a half-dozen times. Now, the question shifts to when the rate hikes might end.
The Fed’s long-term target for the federal funds rate is from 2.75% to 3%. However, in June the Fed’s rate-setting body indicated that rates might peak in the range of 3.25% to 3.5% in 2020 before declining to its long-term target. Although there’s no telling precisely where rates might land, there are several factors investors might want to consider as rates continue to rise.
Heightened credit risk
As monetary policy tightens, you’ll need to pay closer attention to credit risk in your fixed income portfolio, especially where corporate and high-yield bonds are concerned. That’s because issuers of bonds with variable interest rates will have to pay more to meet their obligations as rates reset.
Even fixed-rate borrowers may feel the sting, as lending standards often grow stricter as the cost of credit rises. That means fewer options for companies to refinance existing debt, increasing their odds of default.
In an environment of elevated credit risk, Schwab favors bonds at the upper end of the quality spectrum. If you hold or purchase bonds of lesser quality, make sure your potential upside is commensurate with your increased risk.
Higher yields with less risk
If you’re looking for safety, Treasuries are generally your best bet. Short-term Treasuries’ real yields—their stated yields minus inflation—are finally in positive territory after spending almost a decade underwater (see “The return of the T-bill,” below). Now investors can again turn to Treasuries for income that, not too long ago, would have required more risk.
When the Fed tightens its monetary policy, the difference between short- and long-term rates tends to narrow—meaning there’s less incentive to tie up your money for longer periods.
To mitigate the effects of rising rates, we favor keeping the average duration in bond portfolios in the short-to-intermediate range. That doesn’t mean shunning all long-term bonds but rather keeping the average duration toward the shorter end of the spectrum.
As we approach the end of rate increases for this economic cycle, it’s becoming increasingly tempting to start to add duration to portfolios. Not so fast. Until we see spreads between short- and long-term debt widen again, we suggest sticking with short- and intermediate-term debt.