Investing for portfolio income as rates rise
Joel Dresang: Kyle, let’s talk about investing for income and how that’s changing as interest rates rise. What kind of investment vehicles are we talking about?
Kyle Tetting: Joel, I think most typically what investors are looking at is the interest payments that they get from their bonds, so that fairly regular, fairly consistent and fairly predictable stream of income that comes from bonds.
But it’s important to point out there’s other places that we get income in our portfolio as well, whether it be dividends from stocks, whether it be the monthly rent payments that you might get from real estate you hold. There really are a multitude of sources for income.
Joel: So when interest rates were higher, you would also mention bank CDs and money market funds, but those have sort of eroded as interest rates went down. How did investors respond?
Kyle: It’s been a challenge with interest rates as low as they’ve been that things like money markets, savings accounts and CDs no longer provide any kind of real income for investors. And so we’ve had to reach out a little bit and maybe take on a little more risk than we otherwise might have been willing to do.
As a result, investors who used to be in higher-quality, shorter-term bonds – or higher quality shorter term investments, in general – have had to reach a little bit, take a little bit more risk to get that same level of income that they’re hoping for.
Joel: So now that the Federal Reserve is pushing up interest rates, does that mean investors can invest for income and take less risk?
Kyle: You know, that’s certainly the hope, but, I think it’s important to point out that the Fed has said that rates probably won’t make it as high as they have in the past. That kind of the new normal for rates, or at least the expectation for the new normal, is a little bit lower than where we’ve been in the past.
But I think investors need to be very careful as rates do rise because it can add a lot of volatility for those things which are very sensitive to interest rates – and specifically those things that we typically rely on for income.
Joel: Talk about that volatility. Why is that occurring?
Kyle: So when you look at bonds, you look, for example, at a bond that right now might be paying 2% in terms of its interest rate, and a newly issued bond in a higher rate environment might pay 3%. All of a sudden that 3% bond looks much more attractive. And so, investors in that 2% bond are going to see that the price might go down a little bit to reflect people jumping ship moving into that higher-yielding bond.
Joel: So more volatility in the short term. What about the longer term?
Kyle: Again, I think the Fed has pointed out that it’s unlikely that we get all the way back to where we’ve been historically for rates, at least in the next few years. But I think it will be a much easier environment to invest for income, especially when you look at the fact that rates were as low as they were.
And investors may finally be able to take their foot off the gas a little bit, back off into what should be the safer part of their portfolio, taking a little bit less risk there and getting the kind of income that they hope.
I think investors need to remember that income can come from a variety of sources, that it doesn’t strictly need to be from the interest you get from your bonds or from the dividends that you get from your stocks.
And the S&P 500 is a great example. Since 1926, the S&P has returned 9.8%, but just 40% of that came from the dividend. The other 60% from the price movement, the prices of the stocks moving higher. And so investors really do need to focus on the fact that they can get income from a variety of sources in their portfolio.
Joel: What about that short term volatility that you said that investors should expect? What can they do about that?
Kyle: Investors need to remember to keep safe money safe, that you have money in shorter term, higher quality assets for a reason. It’s a piece of your overall balanced portfolio, and right now you’re not being compensated to take the additional risk.
So, when you’re looking at your safe money, do everything you can to keep it in those shorter-term, high-quality bonds. Keep safe money safe.
Kyle Tetting is director of research and an investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May and Jason Scuglik
Knowing portfolio income vs. withdrawals, a Money Talk Video with Dave Sandstrom
Managing expectations for investments, a Money Talk Video with Kyle Tetting
Strategies for bonds amid rising rates, a Money Talk Video with Marc Amateis
Total return: Your full investment picture, a Money Talk Video with Paige Radke
What investors need to know about volatility, from the Financial Industry Regulatory Authority
Asset Allocation, from the Financial Industry Regulatory Authority
(initially posted July 18, 2017)