This is a weird investing world we are about to enter. And it’s all thanks to the threat of rising interest rates. It’s no secret that the Federal Reserve has kept benchmark interest rates at zero for the last few years as a way to stimulate the economy. While you can argue and draw your own conclusions over whether or not that has been successful at driving economic growth, the one thing it has done is change our perceptions and attitudes on how to invest. Especially if you’re looking for income out of your portfolio.
When you are earning next to nothing at your local savings bank, CD’s, money markets and other traditional savings products aren’t going to cut it.
With that framework in place, dividend stocks and intermediate and long bonds have become the income seeker’s best friends. And there lies the problem; when Janet Yellen finally announces that the Fed is going to raise rates, these traditionally boring and safe investments are going to metaphorically get punched in the face.
An Inverse Relationship
Deep down, the Fed’s impending actions on interest rates are actually a good thing. They basically mean that the economy is finally moving in the right direction. Unfortunately for income seekers, that rate hike is going to cause some unpleasant side effects. Namely, your bond portfolio is going to lose money — potentially a lot of money. One of the basic investing axioms is that bond prices are inversely correlated with the direction of interest rates; the Fed raises rates and a portfolio of fixed-income securities will lose value.
It’s as simple as that.
What’s more is that bonds with longer maturities suffer far more during rate hikes than bonds with shorter-duration. And the longer the maturity of the bond, the bigger the swing in prices. For example, for every percentage point gain in yield, a 10-year Treasury would lose roughly 10% in price. Meanwhile, a 30-year bond would drop around 30%. Those are some hefty losses for what many investors consider safe-haven investments.
There’s the rub. With short-term instruments paying nothing (the iShares 1-3 Year Treasury Bond (SHY) yields 0.47%), many investors have plowed some major dollars into longer-dated bonds to pick up extra yield. And when the Fed raises rates, vehicles like SHY aren’t suddenly going to be paying 6%.
The same could be said for dividend stocks. They’ve been another major recipient of pre-retiree and retired investor cash. In the short to medium run, dividend stocks and ETFs that track them, like the Vanguard Dividend Appreciation Index ETF (VIG), will fall when confronting rising interest rates.
And while you should ignore the Fed over the longer term, if you’re in retirement or getting pretty close, these capital losses could be detrimental to a retirement draw down/spending plan, or rather very detrimental as more and more advisors and analysts are now looking at a total return quotient when it comes to pulling money from a retirement portfolio.
Getting That Total Return Somewhere Else
So with dividend stocks and bonds that actually generate yield now staring down the interest rate gun, what’s an investor to do? The answer is: take a cue from your local university or insurance company.
Liquid alternatives, a hallmark of the institutional investor’s portfolio for years, could be the solution to finding that interest rate risk-free total return needed to plow through your golden years.
Investors may not be familiar with strategies such as long/short, event-driven, or managed futures, but they strive to do a simple thing to generate consistent returns, without the volatility associated with the stock market. More importantly, many are immune to the rise in interest rates.
For example, in merger arbitrage, a fund will seek to profit from the spread that occurs when a buyout acquisition is announced and the final purchase price is set. There’s usually a discrepancy as all deals do have some risk of falling apart. When it closes, the M&A fund keeps the difference. And while that 50 cents or so per share may not seem like much, do it enough times and you’re looking at some serious money. The average M&A fund generates a consistent 5% to 7% in returns a year in up and down markets and is totally independent of whatever the Fed is doing. And this is just one example.
But the ultimate point is that investors now have a sophisticated set of tools to potentially overcome the interest rate issues with both dividend stocks and bonds. Investors looking for a ballast in their portfolios will be better suited in these alternatives.
The Bottom Line
This piece just scratches the surface of using liquid alts. But it should get the conversation going. The matter of fact piece in all of this is that what was considered “safe” is going to turn out not to be when that first rate hike hits. That will come as a shock to some investors, but you don’t have to be one of them.
Image courtesy of renjith krishnan at FreeDigitalPhotos.net
