Many investors are confused and indecisive when it comes to the Fed Follies over interest rates.
The Federal Reserve could bump up interest rates in December, and investors are wondering what portfolio changes they should make as rates lift off ground zero for the first time in seven years. The answers aren’t yet clear because they differ depending on your investing personality and existing positions.
For example, some wonder what to do about the dividend-income stocks they bought because traditional fixed-income instruments weren’t generating the payouts they needed. Bond-loving investors are particularly prone to take action because they distrust the stock market’s volatility and the ability of companies to change their dividend policies at will.
But these investors should hold their fire and take a seat in the wait-and-see camp.
3 rules for investing in bond ETFs
Robert Smith, chief investment officer at Sage Advisory, explains how he has positioned clients for the next Fed move, and how he picks exchange traded funds.
There are a couple of reasons for this: The Fed might not make a move next month. If it does, the rate increase probably will be small — a quarter of a percentage point is a common speculation. Moreover, it most likely won’t be followed immediately by further increases because the Fed will want to study the consequences.
A rate hike that minor won’t compensate for the years of near-zero yields, nor offer much competition to the dividend-income products that sprang up over the past decade. It will take time for fixed income to regain its traditional role as the safe and sane money machine, even if rate hikes eventually come with greater regularity.
Meanwhile, those dividend-rich equity products are delivering cash, some monthly and others quarterly. Only when the same capital investment in bonds would produce as much or more income annually should this type of investor consider moving out of stocks.
By contrast, the game plan is the opposite for investors who are still building the income-generating portion of their portfolio. These investors should stay in the hunt for opportunities, be they equity or fixed income. Not that they should ignore what the Fed does, but use it to their advantage.
For example, most analysts expect the stock market to stumble whenever the Fed takes action. It probably won’t be a severe setback because a rate rise wouldn’t be a surprise at this point, and it might not last long. But investors of this type ought to be ready to buy income-producing securities on the price dip.
Being selective about what to buy is the key to this strategy. The financial sector, mainly banks and insurers, should bounce back quickly because they make more money when rates are higher than they have been. Utilities, which offer juicy dividends, probably won’t recover as fast because they’ll be paying more interest on their debt.
Of course, if the investor is buying for the long term, he or she needn’t worry too much about short-term price fluctuations. Falling prices actually boost dividend yields of stocks. That means investors should look for the ability to sustain dividends. Rising interest rates depress bond prices, which could open up opportunities, such as in tax-free instruments.
Twenty non-leveraged ETFs currently have yields of 9% or more. Of these, five specialize in master limited partnerships. Most MLPs are in the depressed energy sector and their yields are high because their prices have fallen sharply. As long as oil and gas prices stay low, they will have a hard time sustaining those payouts.
Six are currency-hedged foreign equity ETFs. This could be an attractive arena for investors also seeking to grow the international portion of their portfolio. Rising interest rates will bolster the already-strong dollar. But the countries with big currency-hedged payouts are likely to change over time, so they aren’t long-term plays.
Two specialize in mortgages of real estate investment trusts. Rising rates are a two-edged sword in this narrow segment. Mortgage-makers, like banks, make more money at a higher level of interest rates, but the higher rates also reduce the number of mortgages being written.
The remainder is a miscellaneous lot that hold gold-miner stocks, junk bonds, closed-end funds, global stocks and bonds, stocks that support options-trading strategies and one specializing in business development companies. Collectively, they are riskier; all but one has fallen significantly in the past year.
So, investors’ to-do lists in the event of an interest-rate boost depend on personal risk appetites, what their goals might be, and the contents of their existing portfolios. Anybody thinking of making changes should review all three conditions before taking action, or not. Ready-fire-aim almost never ends well.
John Prestbo is retired as editor and executive director of Dow Jones Indexes, now part of S&P Dow Jones Indices, in which Dow Jones & Co., publisher of MarketWatch, holds a small interest. Prestbo also is an adviser to MarketGrader Capital, which scores stocks on the basis of fundamental factors and chooses components of the Barron’s 400 Index.