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SBJ June 2015 Interest Rates and Your Portfolio

SALEM, OREGON                                               JUNE 2015                                                   VOL. 11, NO. 6

 

Let’s Talk: W. Ray Sagner CFP

Interest Rates and Your Portfolio
 

In this month’s column, we will explore how rising or falling interest rates could affect your investment strategies. First, however, let’s have a little primer on the Federal Reserve.

The central bank of the United States, or the Fed, as it is commonly called, regulates the U.S. monetary and financial system. The Federal Reserve System is composed of a central governmental agency in Washington, D.C. (the Board of Governors) and 12 regional Federal Reserve Banks in major cities throughout the United States. You can divide the Federal Reserve's duties into four general areas:

1. Conducting monetary policy –buying and selling government securities and setting the federal funds rate.
2. Regulating banking institutions and protecting the credit rights of consumers.
3. Maintaining the stability of the financial system.
4. Providing financial services to the U.S. government.

The federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. The federal funds rate is generally only applicable to the most creditworthy institutions when they borrow and lend overnight funds to each other. The federal funds rate is one of the most influential interest rates in the U.S. economy, since it affects monetary and financial conditions, which in turn have a bearing on key aspects of the broad economy including employment, growth and inflation. The Federal Open Market Committee (FOMC), which is the Federal Reserve’s primary monetary policymaking body, telegraphs its desired target for the federal funds rate through open market operations. This is also known as the “fed funds rate.”

The higher the federal funds rate, the more expensive it is to borrow money. Since it is only applicable to very creditworthy institutions for extremely short-term (overnight) loans, the federal funds rate can be viewed as the base rate that determines the level of all other interest rates in the U.S. economy and is currently at historic lows.

The federal funds rate has varied significantly over time. It's a cycle of ups and downs that can affect your personal finances, like what rate you pay for a loan or the interest earned on your bank accounts. Interest rate changes also have an effect on your investments and understanding the relationship between bonds, stocks, and interest rates could help you better cope with inevitable changes in our economy and your portfolio.

Interest rates often fall in a weak economy and rise as it strengthens. As the economy improves, companies experience higher costs (wages and materials) and they usually borrow money to grow. That's where bond yields and prices enter the equation.

Yield is a measure of a bond's return based on the price the investor paid for it and the interest the bond will pay. Falling interest rates usually result in declining yields. As rates decline, businesses and governments "call" or redeem the existing bonds they've issued that carry higher interest rates, replacing them with new, lower-yielding bonds.

Interest rate changes affect bond prices in the opposite way. Declining interest rates usually result in rising bond prices and vice versa, one goes up and the other goes down. This opposing relationship is simply described by an investor’s desire for increased cash flow. When interest rates rise, investors buy new bonds for the higher yields. Therefore, owners of existing bonds reduce prices in an attempt to attract buyers.

Investors who hold on to bonds until maturity aren't concerned with this seesaw relationship, but bond fund investors may see its effects over time.

Interest rate changes can also affect stocks. For instance, in the short term, the stock market often declines in the midst of rising interest rates because companies must pay more to borrow money for expansion and capital improvements. Increasing rates often impact small companies more than large, well-established firms. That's because they usually have less cash, shorter track records, and other limited resources that put them at higher risk. On the other hand, a drop in interest rates may result in higher stock prices if corporate profits increase.

In addition, some stocks increase in value even as interest rates rise, in part because industry or company-specific factors -- such as the development of a new product -- can impact stock prices more than rate changes.

All that said, the market also has its ups and downs due to other factors, as well. Fear and greed lead investors to make poor decisions based on the unknown. People tend to sell when they don’t know what to expect with a change in interest rates or that Ebola is going to sweep the country.

So what’s an investor to do when faced with interest rate uncertainty?  While you have no control over changing interest rates, you can assemble a portfolio that can potentially ride out the inevitable ups and downs. Risk reduction begins with diversifying your investments in as many ways as possible.

As for equities or stocks, investing across different business sectors is a start, because no one knows which of today's industries will fuel the next expansion. Keep in mind that some sectors such as energy are more economically sensitive than others, which can lead to increased volatility. Additionally, consider stocks or stock mutual funds that invest in different market caps, small and large companies, and have different investing styles, such as both value and growth investing.

As for fixed-income investments, review your bond funds holdings, for different maturities -- short- and long-term -- and types, such as government and corporate. Different types of bonds react in their own way to interest rate changes. Long-term bonds, for instance, are more sensitive to rate changes than short-term bonds. Still the bottom line is that most bond mutual funds will lose some value as rates begin to climb. That said, there is plenty of time to make changes, as the Fed is not raising interest rates anytime soon. The U.S. economy is still a bit fragile and the rest of the world is a bit behind.

Interest rates will always fluctuate in response to economic conditions. Rather than trying to guess the Federal Reserve's next move, concentrate on creating a portfolio that will serve your needs no matter which way rates go. And remember: portfolio allocation and diversification is key to portfolio success.

The purpose of this article is to inform our readers about financial planning/life issues. It is not intended, nor should it be used, as a substitute for specific legal, accounting, or financial advice. As advice in these disciplines may only be given in response to inquiries regarding particular situations from a trained professional. Ray Sagner is a Certified Financial Plannerä  professional with The Legacy Group, Ltd, a fee only Registered Investment Advisory Firm, in Salem. Ray can be contacted at 503-581-6020, or by email at This email address is being protected from spambots. You need JavaScript enabled to view it. .You may view the Company’s web site at WWW.TheLegacyGroup.com.


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