The following is a guest post from Ben Carlson at A Wealth of Common Sense. Ben writes about personal finance, investments, investor psychology and using your common sense to manage your money. You can follow him on Twitter (@awealthofcs).
If you missed part one of my series on rising interest rates, please read What Happens to Bonds When Interest Rates Rise.
Rising Interest Rates
Rising interest rates are a hot topic in the ever changing investment landscape these days. Historically low rates have forced investors to prepare for the inevitable rate increase.
Investors searching for yield in an environment of low interest rates have had a difficult time finding safe investments that also pay decent income. Money markets, bonds, CDs and other interest bearing assets no longer provide enough income for investors that seek a consistent payout.
Outside of dividend stocks investors don’t have many options. This has led investors to look in places like preferred stocks, high yield bonds and REITs (real estate investment trusts) for income.
Chasing yield can be dangerous, but investors seeking income are left with few choices in a low rate world. Interest rates have little room to fall much further. Investors are now shifting their attention to how these high yielding investments will perform in a rising rate scenario.
Are Rising Rates the Real Problem?
It is definitely possible that we could have a shock to the system and interest rates could rise dramatically in the short-term. But more than likely we will see a slow and steady climb in rates. This will likely occur as central banks around the globe either start selling the bonds they have bought back to the market, or slow the rate of their future purchases.
It is possible that rates scream higher, but the most likely scenario is that rates slowly move higher over time. The diversified portfolios can be rolled over to take advantage of the new higher rates. So while they will have some risk of price loss, the increasing yields will help offset some of those losses. Central banks will do their best to make sure rates don’t head higher in a short amount of time. Governments are borrowing short-term debt so it’s in their best interest to make sure it is a gradual process.
I think that investors are actually looking in the wrong place for the risk of losses in this case. Sure, if and when rates do eventually rise, higher yielding investments will run into some trouble. But if you are investing in preferred stocks, high yield bonds or REITs in the form of a diversified mutual fund or ETF your risk will be spread out and the losses will not be that severe with rising rates.
The bigger risk that investors are overlooking with these new higher yielding investments is what happens when the risk-on trade reverses and markets turn cautious again.
Using History as a Guide
History is not a perfect predictor of the future but you can it as a framework for viewing current and future market decisions. Let’s see how preferred stocks, high yield bonds ad REITs performed in the most recent crisis. For each asset class I will use a corresponding diversified ETF (PFF, JNK and VNQ for preferreds, high yield and REITs, respectively). Here are the total returns for each from October 2007 to February 2009:
This was a huge crash that also saw stocks drop over 50% in some markets. Many investors were looking for any source of liquidity that they could find since credit markets were basically frozen. These three assets were lumped in and it was a case of throwing the baby out with the bath water. They have all since performed very well, although JNK and PFF have still not reached their 2007 peaks.
The point is not that you can expect losses of this magnitude if you invest in these assets, but just that they can sell off in a downturn. Let’s look at a more run-of-the-mill sell off in risk assets that occurred in mid-2011 to see how they held up. From July to September of 2011 the European debt crisis caused stocks to sell off roughly 20%. Here’s how these higher yielding investments fared:
The performance was not nearly as bad as the losses in the 2007 to 2009 period but there were losses nonetheless. You can see that they all outperformed stocks (bond returns would look much better).
Since these securities are all hybrid investments that share both bond and stock characteristics you can expect them to perform somewhere in between those two main asset classes.
The main takeaway here is that you do have to worry about rising rates when investing in high yield investments, just not as much as you may think. The much bigger risk is what can happen to these investments when markets sell off as they have been periodically shown to do in the past.
As always, do your homework and think about the risks involved with your investments before you think about the returns.
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