High Inflation & Rising Interest Rates: How Should Investors Respond? (Part 2)
As we discussed in the first part of this two-part series, interest rates are climbing as the Federal Reserve acts to stem surging inflation. Investors are now asking how they should respond to these developments — and in the previous post, we discussed two ways: utilizing alternative investments and constructing a bond ladder with municipal bonds or corporate bonds.
In this post, I outline an additional strategy and products that investors should consider, in response to the current market dynamics.
Diversification: Building a diversified portfolio of stocks and bonds is another strategy to mitigate risk, as inflation and interest rates rise. Ideally, this means building an allocation percentage to stocks based on your risk tolerance and the right mix of fixed income securities. To that end, the following types of fixed income securities are excellent options for investors diversifying their portfolio:
● TIPS: Treasury Inflation-Protected Securities are bonds whose principal and interest rate payments climb along with inflation and are available in 5-year, 10-year, and 30-year maturities. The inflation protection offered by TIPS adds to their price. TIPS are more expensive than conventional Treasury bonds to purchase, but they offer diversification during higher inflation.
● Short Duration Bonds: Short-term bonds, or fixed-income securities with a small amount of time to maturity, are less likely to fall in price due to rising rates because rates are less likely to move up or down over a short period. These bonds are considered liquid, easily accessible, and relatively safe.
Asset management company PIMCO explains that the price of a bond with a one-year duration would decline by 1% if rates rose by 1%. In contrast, a bond with a10-year duration would lose 10% (price drop) if rates climbed 1%.
Long-term bonds are considered more susceptible or at risk from rising inflation rates than short-term bonds. Inflation causes bond yields to shoot up, and rising yields hurt long bonds more than short bonds. That's because there is a greater chance that interest rates will increase and lower the bond's market price over a more extended period than within a shorter period.
● Convertible Bonds: These bonds, hybrids with characteristics of both bonds and equities, have historically performed better than traditional fixed income assets during periods of rising rates and have also helped moderate equity market volatility. They have fixed-income qualities and can be affected by rising interest rates. Still, they also can take on equity qualities because of the issuer's option to convert them into a predetermined number of issuer shares.
Using these products, investors can build a portfolio that appropriately manages risks in the current environment.
The three strategies outlined in this series — alternative investments, a bond ladder and diversification — can help investors protect the value of their investments and find opportunities to benefit from the changing market dynamics. At Farther, we are confident that we can assist you in selecting investments that are appropriate to help diversify your portfolio and meet your investing objectives.