Financial Management

 Following the recent market flux, investors are especially attentive to the direction of rising interest rates. Although some may focus on the negatives associated with a potential increase, there are several positive aspects for investors. Here is one way the rising rates might be a welcome development:
Income Investors May Be Able to Take Less Risk
For many investors, the last six years’ zero-interest-rate environment has caused them to take greater risks to generate income from their portfolios. Before the global financial recession, income investors had the ability to buy low-risk certificates of deposit that provided returns above 5%. Today, due to the Fed’s easy monetary policies, traditional lower-risk, income-generating investments offer little in the way of income.
Solutions in the marketplace have emerged to help fulfill income investors’ needs. The ability to achieve a yield in excess of short-term Treasury yields does not come without risk, regardless of the strategies employed. Many income solutions employed in today’s market incorporate strategies such as:
Extending maturities
• Moving lower in credit quality—often to below investment-grade levels
• Employing leverage
• Using financial derivatives
Many of these strategies have performed well in recent years. As the Fed slowly raises interest rates, however, strategies that have proven effective in the past may face challenges as investors have the ability to reduce risk while still meeting portfolio income requirements. Furthermore, many of the most popular income-producing strategies have not been stressed during a significant credit shock or a sustained increase in interest rates.
Price shocks in the fixed-income space could potentially be more significant and volatile in the future given the reduction of fixed-income liquidity in the market due to consolidation and regulatory reforms. The changing fixed-income market makes it difficult for investors to fully appreciate the potential risks inherent in the search for yield. With the Fed intent on moving slowly, it may take time before investors once again find they need to take less risk to help achieve their income goals.
Addressing retirees’ unique income needs
Generating income is particularly important to those in retirement. If you are retired we recommend you:
• Focus on diversification of your income sources. If your portfolio contains an over-allocation to fixed-income investments with longer maturities/durations that you’ve purchased in recent years in an effort to enhance yield, you should think about reallocating your portfolio.
• Reassess your asset allocation. As your investment needs and financial goals change, your investments and risk tolerance should change as well. A regular asset allocation review is important to help ensure your investments are aligned with your financial goals.
• Avoid chasing or becoming overly preoccupied with yield. Be careful to maintain a total-return (price appreciation plus dividend or interest income) perspective because when investing over a long retirement, you will likely need both income and growth to fund future income needs and combat inflation.
• Keep a close eye on your income needs and related liquidity. The risk of incurring substantial principal loss during a rising-rate environment is compounded by the potential need to liquidate certain holdings during these periods. However, you may be able to reduce your potential principal loss if you are careful to match and adapt your spending habits with your income flows and can avoid forced liquidations by having sufficient cash reserves or other assets and available credit.