Video Transcript
Jason Stipp: I’m Jason Stipp for Morningstar. The direction of interest rates is, at best, a guessing game. But if rates do go up, as the consensus is starting to expect, what might that mean for retirees? Here to offer some insights is Morningstar’s Christine Benz, our director of personal finance.
Christine, thanks for joining me.
Christine Benz: Jason, great to be here.
Stipp: A lot of folks do expect interest rates to go up, but it’s kind of a guessing game to say that rates will go up. We’ve thought they'd go up for a while.
Benz: That’s right. In fact, I was looking back on some of my past articles, and I think even back in 2010 and 2011 I was talking about potential strategies if you were interested in combating a rising-rate environment. So, it’s certainly a guessing game. We see this with professional fund managers, too. A lot of fund managers over the past several years have really been caught leaning the wrong way when trying to predict the direction of interest rates. So, it’s a tricky business, to be sure.
Stipp: But we do have the Fed pretty much signaling that they do expect to raise rates in 2015, so there is a good chance anyway that we will see higher rates. And there are some good things that higher rates bring, and there are some bad things that higher rates can bring. Let’s start with the good. The first one is that the short-term instruments that I have will finally start to give me some kind of yield.
Benz: Exactly. That’s one positive associated with rising rates. Yields, in fact, do begin to rise. I found it pretty interesting that a few months ago we had a discussion on Morningstar.com in one of our Discuss forums, talking about rising rates. And actually, the majority of posters said that they expect more good to come out of a rising-rate environment than bad. They are very much looking forward to being able to earn a higher safe return on their money. That’s something that investors have really been starved for over the past several years.
Stipp: We do think that if rates go up, they probably will go up in a fairly orderly way, or it seems that some signs indicate they would--because if rates spike, then it usually is tough for a lot of different parts of the market.
Benz: That’s right. And of course, it’s difficult to say exactly how rising rates will unfold. But certainly, when you think about the U.S. economy right now, it appears to be in relatively stable-growth mode, not in sort of a meteoric-assent mode. And that would tend to bode well for a stable unfolding of rising interest rates as opposed to a really abrupt spike. But here, again, it’s very difficult to predict.
Stipp: So, if rates rise as the market expects, there’s usually less of a shock, and then you can benefit from some of those higher yields.
Benz: That’s right. Some of it’s priced in to bonds, currently.
Stipp: That’s right. One of the things I think people worry about is the effect of rising rates on stocks, but there might not be a whole lot of bad news there if we do see rates gradually rise as the economy is expanding.
Benz: That’s right. When you examine previous periods in which interest rates have risen and you look at, say, the S&P 500’s return during those time periods, what you tend to see is that stocks tend to behave reasonably well during those periods. The key reason is that the stock market is responding mainly to the economic growth that is often precipitating those interest-rate increases. So, that’s the main thing that the stock market will respond to--secondarily will be what’s going on with rising rates. Of course, how this particular rising-rate environment will unfold is anyone’s guess; but when you look over past historical periods, it hasn’t been a terrible period for stocks when interest rates have been on the move upward.
Stipp: So, higher yields can mean higher yields for your savings and your [certificates of deposit] and shorter-term bonds finally giving you some yield. But also fixed-annuity products might [be given] a little lift, because it hasn’t been a great time with yields so low to be in those products.
Benz: That’s exactly right. So, when insurers are taking in consumers’ money and [those consumers] are going to make them make annuity payouts over the years, what [insurers] are looking at to determine those payouts is really what sort of safe yield they can earn on investors’ money at that point in time. So, given how low current yields are, insurers have had to price annuities relatively unattractively. So, payouts for new buyers have not been particularly high. When we do see higher yields, I think that that environment could improve for potential annuity buyers.
Stipp: Another insurance product that consumers could benefit from [in the event of] higher yields is long-term care insurance. So, what might be the beneficial impact there?
Benz: There, again, the policy is priced based on whatever the insurer thinks it can earn on the insured people’s money as they take it in. And so, the premiums have been on the increase for long-term care buyers; people who hold the policies have seen pretty shocking rate increases over the past several years. That situation could probably become better in a period of rising interest rates--another potential tailwind for long-term care insurance buyers. This is something that financial-planning expert Michael Kitces has pointed out. Insurers are being more realistic about the claims that they will pay. They have more information about the likelihood of claims from long-term care policyholders, and so he thinks that they are pricing those policies more realistically. That, too, could help tamp down premium increases that we’ve seen in the long-term care market.
Stipp: So, some potential benefits from rising rates for retirees over time. But there are some dark sides to rising rates, and I think one of the biggest ones is that folks who already hold fixed-income investments, bond investments, those can get crunched as rates rise.
Benz: That’s right. So, when you think about why this happens, it’s because when there are new higher-yielding bonds on the market, that makes the existing pool of lower-yielding bonds less attractive. People don’t want to hold them, so their prices decline during that period. That’s one thing we’ve seen a lot of handwringing about, especially for bond-fund holders. There’s been a concern that if rates begin to rise that that existing pool of bonds in the portfolio will see their prices depress. So, investors have been concerned about that--and reasonably so. Because when we have looked at previous periods of rising rates, even that “taper tantrum” that took hold in the summer of 2013, what we have seen is that certainly long-term bonds can get crunched during periods of rising rates.
Stipp: So, if I want to try to figure out how much they might get crunched, there are a few factors to consider--because if rates are going up, those managers conceivably can also be rotating into higher-yielding investments.
Benz: That’s right. Ken Volpert at Vanguard shared what he calls a “duration stress test,” and what you’re looking for is the duration on a bond mutual fund that you hold. Find that number either on Morningstar.com or on your fund-company website, and then find a Securities and Exchange Commission yield. With those two numbers, subtract that SEC yield from the duration; the amount that you’re left over with is a rough approximation of what you might lose in a one-year period if interest rates shot up by one percentage point. So, that’s a stress test that you can run. The nice thing about the stress test is that it accounts for the fact that, as rates go up, you’re getting part of that higher-yield back.
Stipp: Again, as you’re doing that stress test, you’re likely to see that some of the most vulnerable fixed-income funds or fixed-income investments will be the longer-term ones.
Benz: That’s right. So, when you think about the duration on a long-term bond index portfolio today, it’s about 14 or 14.5 years, whereas the SEC yields at this point are well under 4%. So, that’s a 10-percentage-point difference. That 14-year duration minus that 4% yield is a roughly 10% loss in a one-year period in which rates go up by one percentage point. So, that’s certainly something to contend with if you’re one of those investors who have been looking longingly at the really nice returns that we’ve seen from long-term bonds over the past few years.
Stipp: If we do see rates rise, not only might it affect your domestic U.S. bonds, but there is a potential impact on other related assets, including overseas bonds.
Benz: Absolutely. Any security type that investors look to as a source of yield could potentially be vulnerable in a period of rising rates. The reason is that if an investor can own, say, a U.S. Treasury bond and earn a competitive yield on that money, why would they want to own some of the riskier assets that might have yields in that same ballpark? Again, going back to that taper tantrum, we saw all manner of securities sell off pretty sharply: Emerging-markets bonds performed very badly; Treasury inflation-protected securities performed badly; even high-yield performed poorly during that time. So, it won’t just be high-quality bonds necessarily that are vulnerable in such an environment.
Stipp: We mentioned before that the stock market, as a whole, probably could do OK in a gradually rising-rate environment; but some parts of the stock market will be more vulnerable to rising rates.
Benz: Absolutely. I think that the higher-yielding equity types will tend to be the most vulnerable. So, when you think about utilities, real estate, anything where that yield attached to the security is a big part of the value proposition, those securities will tend to be the most vulnerable. I think investors also want to have valuations in mind at this point. When we look at our price/fair values for the various sectors that our analysts are covering, what we see is that some of the more yield-rich sectors are actually the most expensive right now, too. Here, again, utilities, real estate, consumer-defensive stocks, health-care stocks. All historically are pretty good sources of yield for investors. All have price/fair values that are well above fair value--in the neighborhood of anywhere from 1.05 to 1.1, currently.
Stipp: Lastly, when we do see rates go up, historically something else is usually going up and that’s inflation. So, you might be getting a higher rate on some of your fixed-income investments, but you might also be paying more at the grocery store or at the gas pump.
Benz: That’s right. So, when interest rates are on the move, it’s often when the economy is performing well and inflation is often on the move at that time. So, what the market gives with one hand in the form of higher yields, it may be taking away with the other in the form of inflation. Think back to the period in the mid-80s, for example, when inflation was at a very high level. Yields were very, very high at that point, too; but inflation really was tamping down investors take-home yield because of those higher prices.
Stipp: So, there are upsides and there are some downsides to higher rates. The important thing is to really understand the different kinds of impacts and to be prepared for them. Thanks for joining us today, Christine.
Benz: Thank you, Jason.
Stipp: For Morningstar, I’m Jason Stipp. Thanks for watching.
