The Federal Reserve finished the year with yet another interest rate hike. If inflation slows as expected, analysts still expect further increases of at least 75 basis points. You know how rising rates hurt your retirement savings, but there are ways you can take advantage of them.
Benefiting from an environment of high interest rates isn’t new, and it isn’t rocket science. These strategies have been employed for generations—when rates were high. Over the past two decades, with the Feds employing quantitative easing to keep interest rates low, you had little opportunity to use these approaches.
Here are four scenarios where you can benefit from rising interest rates:
Reduced Inflation Risk
The Federal Reserve increased interest rates to combat inflation. At least, that’s the theory. Let’s hope it works and that this isn’t another example of the generals fighting the last battle. Assuming the Fed meets its objective, then rising rates will reduce inflation. Everyone benefits from that in a variety of ways.
“When interest rates rise, the cost of borrowing money increases, meaning investors have to pay more in order to borrow,” says Teifke. “This makes it harder for people and businesses to take out loans, reducing the risk of inflation. This could be beneficial for retirement savings investment portfolios as it could mean a more stable market and better returns on investments.”
Safer Investments Offer Higher Yields
If you have a variable rate mortgage or if you seek a mortgage, you know what happens when rates rise. The cost of servicing your debt increases.
The same applies to fixed-income bonds and dividend-oriented stocks. The yields on these securities reach new heights. Even your bank accounts start spitting out higher interest payments. When interest rates approach zero, these “safe” investments are no better than stuffing your money into a mattress. As interest rates rise, these same investments start paying out attractive dividends and interest.
“Some benefits of rising interest rates are higher rates on fixed-income investments and savings,” says Mary Popovic, Senior Investment Analyst at Wealth Enhancement Group in Madison, Wisconsin, says, “Over the past several months, we’ve seen a complete turnaround compared to the last decade in higher CD rates, treasury yields, bond yields and money market rates.”
What does this mean for you? It means you can now take a different approach to your total savings philosophy. The Fed’s actions have just added more arrows to your investment quiver. You can once again seriously consider safe alternatives.
“The biggest benefit to retirement portfolios when interest rates rise is the ability to gain yield on very conservative investments,” says Herman (Tommy) Thompson, Jr., Financial Planner at Innovative Financial Group in Atlanta. “For the first time in over a decade, investors can now receive over 2% in money market instruments and short-term treasury obligations. While these yields are still far below inflation, there is a positive attribution to your total return instead of a big zero.”
Cheaper Securities Prices
It’s not just higher yields. Another result of rising interest rates offers you an appealing prospect.
“There is an inverse relationship between yield and price,” says Popovic. “As interest rates increase, so do yields, but, in turn, the price of bonds (and, generally, equities) will fall.”
While most of your focus may be on higher yields in bonds, stock investors can also uncover chances that haven’t been available for some time.
“Second, retirement savings portfolios that are invested in stocks can also benefit from higher interest rates,” says Tommy Gallagher, an ex-investment banker and the Founder of Top Mobile Banks who lives in Berne, Switzerland and Ann Arbor, Michigan. “Higher interest rates tend to make stocks more attractive to investors, as they can generate higher returns than fixed-income investments. This can lead to a rise in stock prices, which can result in higher returns for those who have invested in stocks.”
If you’re still regularly contributing to your retirement account, discounted prices on all securities provide you with the ability to dollar-cost average. Buying lower today can help you sell higher in retirement.
“While rising interest rates hurt current retirement savings in investment portfolios, they offer an opportunity to invest in stocks funds and bonds funds at a discounted rate,” Avanti Shetye, Founder of Foolproof Financial Freedom in Ellicott City, Maryland. “As you add more capital to your retirement savings, you can deploy this additional capital to earn more over your target horizon.”
Less Portfolio Volatility
If you’re a value investor, you know why this is true. Ben Graham recommended “Intelligent Investors” need to compare their investment candidate with the “risk-free rate of return.” The risk-free rate of return refers to the interest rate offered by the safest investment alternative.
For many, the risk-free rate of return might be the current coupon rate of five-year treasuries. Today, it’s a shade below 4%. A year ago, it was barely over 1%.
Think about what that means when you invest in stocks. A year ago, you just had to be sure your stock would earn more than 1% per year over the next five years. Today, such investment candidates need to earn 4% or more annually. Naturally, this will diminish the demand for stocks. As mentioned, one result of this will produce lower prices in stocks.
But reduced demand leads to another result: lower volatility.
“Rising interest rates tend to reduce volatility in the markets as investors become less likely to take risks when they know they can get a higher return on their investments,” Matt Teifke, Founder and CEO of Teifke Real Estate in Austin, Texas. “This could mean a smoother ride for retirement savings investment portfolios during times of market uncertainty.”
Take heart. Higher interest rates may hurt in the near term, but if you play your investment cards right, you’ll do well in the long term.