Income portfolios use a strategic mix of investments to generate cash. So how are they impacted by interest rate increases?
As we look down the economic road ahead, we see the distinct prospect of rising short-term interest rates with years upon years of rates at near zero in the rearview mirror. In fact, the Federal Reserve raised short-term interest rates three times in 2017 and has raised them twice so far in 2018, with further increases expected before year end. These changes can send ripples throughout the financial markets. And since income portfolios rely on a strategic mix of stocks, bonds and other investments to generate cash, many are wondering what impact these variables will have on investment income. Let’s take a look at the options.
When interest rates increase, bond values decrease. If rates for intermediate- and long-term maturities continue to rise, bond prices will decline and yields will increase. However, though the value of bonds may be expected to decrease, the interest paid will continue and cash flow will remain unchanged. As bonds mature, income investors now enjoy an opportunity to reinvest the proceeds at higher yields, increasing their incomes. Even if prices are lower, it isn’t necessarily a bad thing. If individual bond owners simply hold their bonds to maturity or call, they will receive the par value, barring default. Remember, bonds that have shorter-term maturities tend to be less sensitive to interest rate hikes.
Among experts, moderate-yield dividend growers are believed to have more stable cash flows than their non-dividend-paying counterparts, especially in times of moving interest rates. While small-cap companies generate excitement (i.e., volatility), dividend growers move steadily along in a more mature and predictable way. These are companies with generally low debt load and a stable fixed-capital structure. When sales move upward, margins widen and dividends can rise.
On the other hand, high-yield dividend stocks may underperform their low- to moderate-yield counterparts when interest rates are on the climb. These are companies that bear the brunt of rising finance costs due to lower cash flow. Consequently, high-yield stocks tend to behave more like bonds and are more likely to experience a negative impact when rates rise. Though not to be avoided, these equities require more scrutiny, and your advisor can help you parse the details.
Due to their relatively reliable dividend, real estate investment trusts (REITs) are often found as instruments of diversification in portfolios of income-oriented investors. Though it may seem counterintuitive to think of REITs as performers when interest rates rise – since rising rates equal higher prices for borrowing money – REITs can be made up of business rental and industrial properties that are less sensitive to the upward movement of interest rates. As a result, real estate companies have the potential to earn reliable streams of income from long and stable tenant leases. What’s more? REITs must distribute at least 90% of their taxable income to shareholders as dividends.
In the past, if you were looking for a steady, reliable, fixed income performer in your portfolio, an annuity fit the bill. A fixed annuity purchase meant paying a sum of money for the promise of fixed cash flow in the future. If interest rates increased, however, you were still where you started. Thankfully, times have changed.
A fixed indexed annuity with a lifetime income feature enables the purchase of cash flow at a discounted rate. What may make this feature attractive is the purchaser still owns and controls the account value that grows at a reasonable rate similar to fixed income rates today (comparable to corporate A-rated bonds), and this account would pay out as a death benefit if the purchaser dies prematurely. The benefit of adding an income rider is that funds may grow at a much higher rate, enabling the purchaser to enjoy higher cash flow from the account value, which is also guaranteed. If, however, interest rates improve by the time the owner retires, or is already receiving income, the remaining account value balance can be converted back to a traditional fixed income investment or another product type (CDs, bonds, etc.) that may pay more. Now that’s flexibility.
Of course, there is no set trajectory when it comes to the future – including interest rates – and that’s not necessarily a bad thing. The biggest tax bill in 30 years is now in effect, and companies are touting expansion, bonuses and raises. Billions of dollars of U.S. corporate capital are also forecast to repatriate. That’s why it’s important to stay in touch with your advisor. He or she can review your portfolio in light of all the changes that are taking place and discuss how they may affect your future earnings and cash flow.
Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur. Past performance is not indicative of future results. Legislative and regulatory agendas are subject to change at the discretion of leadership or as dictated by events. Dividends are not guaranteed and must be authorized by the company’s board of directors. Investing always involves risk and you may incur a profit or loss. No investment strategy can guarantee success.
The value of fixed income securities fluctuates and investors may receive more or less than their original investments if sold prior to maturity. Bonds are subject to price change and availability. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.
Be advised that investments in real estate and in REITs have various risks, including possible lack of liquidity and devaluation based on adverse economic and regulatory changes. Additionally, investments in REITs will fluctuate with the value of the underlying properties, and the price at redemption may be more or less than the original price paid. Real estate investments can be subject to different and greater risks than more diversified investments. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments. Please consult a qualified tax professional regarding your particular situation.
Fixed annuities have limitations. If you decide to take your money out early, you may face fees called surrender charges. Plus, if you’re not yet 59½, you also may have to pay an additional 10% tax penalty on top of ordinary income taxes. You should also know that a fixed annuity contains guarantees and protections that are subject to the issuing insurance company’s ability to pay for them. Withdrawals from annuities will affect both the account value and the death benefit. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost.