Readying for Higher Interest Rates

Nanigian also recommends that advisors who are concerned about interest rate risk consider floating rate note mutual funds that adjust coupon payments in response to changes in interest rates. A caveat is that these funds can be risky. "They may be subject to large downside risk in the event of a 'fire sale' by fund shareholders," he says.

Cash-Flow Matching

For those who are saving for a specific goal, such as spending in retirement, matching the payout of the bond to the spending need can insulate the investor from cash flow volatility. Nanigian says that an advisor can create a "cash flow matching" portfolio by "constructing a client's portfolio such that the anticipated cash inflows (from principal and interest) match the anticipated income needs of the client."

The downside of cash flow matching is that bonds held within a portfolio will still fall in value if interest rates rise even if they aren't sold until maturity. And cash flow matching using nominal bonds provides no protection against inflation. However, it does ensure that a client will be able spend a specific amount of future dollars without worrying about what happens in the market.

The risk of a spike in interest rates is less of a worry for clients who hold a significant amount of cash value in a life insurance policy, says James Brocke, a financial planner at MassMutual Midwest. This is because some institutions can smooth bond returns across generations of policyholders to reduce annual return volatility. In my own recent research, I've estimated that this smoothing can be particularly beneficial for a new retiree in preserving their ability to fund a spending goal into old age.

And it's not just life insurance that provides this smoothing value. Many workers have the option of investing in a stable value fund within their retirement accounts. These stable value funds are constructed to shield bond investors against losses while providing a higher return than cash. The downside of stable value funds is that they often have a shorter duration and have underperformed longer duration bonds historically.

Strategies for a Rising-Rate Environment

Interest rate cycles do indeed tend to be long-term mean reverting. They go up for a couple of decades and go down at the same rate. It's been a long time since interest rates have risen, so it's worth studying what happens to asset returns when the Fed decides to start raising rates.

Between 1960 and 1980, long-term bonds got trounced. They provided an average annual return of 1.9% and a standard deviation of 6.56%. Short-term bonds averaged a return of 3% with a standard deviation of only 2.35%. This is a reminder that even though long-term bonds have outperformed historically, they can underperform for a long time, all the while punishing investors with more than twice the volatility of short-term bonds.

One asset with returns that resemble a long-term bond that has performed well in a rising rate environment is equity real estate investment trusts, or REITs. Johnson has estimated that equity REITs had an annualized return of 9.8% when rates were rising. Mortgage REITs are another story. He estimated that mortgage REITs fell by an average of 4.1% per year in a rising rate environment.

Rising rates can do a number on a well-diversified portfolio of both bonds and stocks. According to Johnson, "Historically the overall equity market has performed dramatically better when interest rates were falling than when rates were rising ,and I see no reason to expect any different relationship moving forward." In his research, he found that from 1966 through 2016, the S&P 500 returned 15.2% when rates were dropping and only 5.8 % when rates were increasing.

Some stocks are particularly prone to under-performing in a rising rate environment. Johnson notes that "small firms have struggled during a rising rate environment and the well-documented "small firm effect" has been concentrated in falling interest rate environments. Investors may want to lighten their small firm exposure in anticipation of a secular rising interest rate trend."

The Good News

What investments have performed well when interest rates rise? Sectors whose business model is not dependent on consumer borrowing, such as energy, utilities and consumer staples like food products, do just fine. Sectors such as autos, construction and retail tend to underperform.

Energy, utilities, consumer goods and food outperformed in rising rate environments. On the other hand, apparel, retail, autos and construction outperformed in falling rate environments. "This makes sense as people need to put gas in their automobiles, heat and cool their homes, brush their teeth, and eat, whether rates are moving up, down or sideways," notes Johnson.

A particularly attractive asset class during a rising rates environment is commodities. Johnson's research finds that the Goldman Sachs Commodity Index returned 17.7% annually during rising interest rate environments, while losing 0.2% annually during falling rate environments. The one exception is gold, which has proven a surprisingly ineffective hedge against interest rate risk in the past.

In addition to commodities, emerging markets (with economies that are often commodity-based) can become a more attractive. "If one is looking for global exposure, emerging market equities have historically outperformed developed market equities during rising rate environments," notes Johnson.

Although it has been a long time since we've seen a push toward rising rates by the Federal Reserve, there are a number of lessons from history that can help advisors guard against the risks of a rising rate environment. Moving toward sectors that have proven effective shelters against the storm of higher interest rates can be a sensible strategy.

Michael Finke is head of The American College on Financial Planning and a regular contributor to Investment Advisor.