The last few years we’ve seen historically low-interest rates and a rising concern over interest rate risk. These low rates have been great for borrows looking for low-cost loans. On the other side, it’s been tough on savers forced into short-term fixed income assets while they wait for rates to rise.
It’s not a great combination for those looking to invest in fixed income assets. All we can do is avoid or reduce the risks we take when dealing with changing interest rates. The best way to digest it all is to understand interest rate risk, its effect on different assets, and how to mange it all.
What Is Interest Rate Risk?
Interest rate risk is the risk inherent with loans, bonds and other interest bearing assets. It’s due to the movement in interest rates over time. The simple version is seen with bond prices and yields. As interest rates rise, bond prices fall and vice versa.
While bonds have a fixed interest rate, real interest rates are constantly changing. This is where interest rate risk presents itself. When rates move too much in one direction it has a significant impact on bond prices.
How can we measure interest rate risk? Through duration. For bonds that would be maturity. A longer term maturity is much more sensitive to interest rate changes than short-term maturities. When rates are low, focusing on short-term bonds offer the least amount of risk. When rates are high, long-term bonds should be the goal.
More Than Just Bonds
Interest rate risk is not limited to bonds. It can affect the prices of mutual funds and ETFs holding bonds, loans, and assets with bond-like characteristics like REITs and preferred stocks.
The big benefit of bond funds is easy diversification. But it doesn’t make them immune to interest rate risk. Bond funds have a similar reaction to interest rate changes as an individual bond. Funds that focus on long-term bonds like a long-term government bond fund are most at risk.
When rates are low, our focus should be on short-term funds. When rates are high, we can change course and move into those longer term funds.
We do take risks by taking out loans. The biggest being loss of income and not making payments. The next, is being locked into a high interest rate as rates start to fall. The goal when borrowing is to pay the lowest costs or rates possible.
When rates do fall, refinancing to a lower rate is the easiest way to save money on long-term loans, lower the total loan cost and reduce risk. Of course, as rates start to rise, locking in a low rate will save you a significant amount of money over the course of the loan. This is more important for longer term loans like student loans or mortgages where payment schedules can last 15 years or more.
We recently covered the real estate investment trust. REITs have similar characteristics as bonds. Much of it is due to demand or lack of demand as interest rates change. REITs are relied on as income producers, thanks to high dividend payouts.
In high interest rate environments, the demand for REITs can drop, having a negative effect on share prices. In low-interest rate environments, the demand for REITs can rise, increasing share prices.
Other things to consider are the type of assets the REIT owns. Mortgage REITs own mortgages or mortgage-backed securities. A low-interest mortgage portfolio is a red flag when interest rates are rising. The same goes for equity REITs with a large amount of long-term leases.
Like REITs, preferred stocks also have similar bond characteristics. Preferred stocks usually pay a fixed dividend and can have a very long or infinite maturity date. This makes them very susceptible to interest rate competition from corporate bonds.
When interest rates are falling, investors are willing to pay more for preferred shares because the dividend yield is better. As rates start rising, investor demand moves to other higher yielding assets like corporate bonds. The best time to own preferred shares is when corporate bond rates are just starting to fall.
For the average investor, the best way to manage interest rate risk is to change your fixed income asset allocation. When the risk is high, we lower our allocation in bonds and other fixed income assets. As the risk falls, we can move money back into those interest bearing assets. Throughout the process, we take advantage of short and long duration bonds and loans as interest rates change.
Risk management is the best reason to take an active role in your investment decision-making. A few minutes each week spent reviewing potential risks will give the average investor a head start on loss prevention. It’s the best kind of defense available and it will lead to better long-term gains.