The prospect of interest rates increasing in the near future is inevitable. Many expect later this year for interest rates to start creeping up in 0.25 percent increments. Investors have been keenly aware of these low interest rates with the low interest payments offered by bonds, bond funds and other fixed income-like (or interest bearing) investment vehicles.
The question before many investors is what these increased interest rates mean for some of the fixed income investments in their portfolios. Also, a number of investors have taken on more risk with higher yielding fixed income investments. Yield ranges mentioned below are as of Aug. 31, 2015.
Municipal Bonds and Their Risks: Yields are typically in the 2-3 percent range right now. Despite the low yields, this interest is exempt from federal taxes. Also, if you buy municipal bonds issued by your home state, they will most likely be free of state income tax. For someone in the 39.6 percent income tax bracket, a 3 percent bond is the equivalent of a 5.3 percent taxable bond. Municipal bonds typically don’t make sense for someone in a low tax bracket. The possibility of default exists because some state and municipal finances are on shaky ground, as has been the example with Detroit and Puerto Rico. Also, as interest rates rise, the value of these bonds may fall. If you own individual bonds and hold them to maturity, the investor’s biggest risk becomes inflation, which eats at the value of the investment.
Investment Grade Corporate Bonds and Their Risks: These are typically yielding 2-4 percent. Here the default rate is quite low. The risk, again, is as interest rates go up, the values of these bonds go down. There is also always the possibility that a company could have an issue with bankruptcy. Shorter term bonds of 3 to 5 years, can help reduce the interest rate risk a bit.
Floating Rate Loans and Their Risks: These are paying around 3-4 percent. These are IOUs that banks make to borrower companies with below investment grade ratings. They are tied to a short-term interest rate and reset every 30 or 90 days. The rate is higher because of the lower quality of the borrower. With interest rate adjustments made periodically, these instruments can protect the lender from interest rate risk. This is a small niche market and can be less liquid and less efficient. Funds have been created with floating rate loans, but can often contain junk bonds or other types of debt.
Preferred Stocks and Their Risks: These are paying around 5-7 percent. These assets trade like stocks and pay fixed dividends. Often preferred stocks pay a qualified dividend so that they are only subject to a 15 percent income tax. They do not have a set maturity date like bonds. Problems can occur if the issuer has problems and decides to suspend the dividend. These securities, because they have no maturity date, are highly susceptible to increases in interest rates. As interest rates rise, the value of preferred stocks may go down.
Master Limited Partnerships and Their Risks: Essentially MLPs are the energy infrastructure here in the United States, including oil and gas pipelines. They receive favorable tax treatment to encourage the building of our energy infrastructure. This has been a popular area for investors to find yield post-2008 and up until the downturn in oil prices over the past year. They have a unique pass through mechanism whereby they avoid paying corporate taxes and pass the income through to the investor. Yields have been in the 4-8 percent area. They also issue K1s instead of 1099s. They have been heavily impacted by the fall in oil prices of recent, as new drilling and expanding of the U.S. energy infrastructure has pulled back.
REITs and Their Risks: The real estate world has been generating 7-14 percent interest rates in REITs. This is also an area where as interest rates rise, the values of REITs can go down. When the leverage in REITs (loans to buy the properties) is highest, the REIT can be more susceptible to interest rate hikes. The other thing to look at is if the rents or mortgage payments coming into the REIT are variable or not. If there is a variable component, the amount the REIT is being paid by the properties may go up as the cost of the leverage increases. This can help reduce the negative impact of rising rates.
In the end, the lower volatility of some of these instruments is something to consider in an investor’s entire asset allocation. Please consult with your financial professional before making investment decisions, especially in light of this article. (Note that this article is only a brief window into any of these investment vehicles, and is not meant to be all inclusive as to the risks and rewards of these investments.) Volatility is to be expected in an environment with increasing interest rates. It is best to make sure, with the advice of your investment professional, how your overall portfolio can best weather this oncoming increase.