How many times have you ducked out of a meeting, or were caught up in something else that required your attention, only to get the itch? You know, the one nagging you to sneak a peek at what your favorite stocks were doing.
Yep, been there before. But then again, name an investor who isn’t guilty on that front!
We can’t ignore the fact that we are a species born of inherent curiosities. And when it comes to anything that involves money slapped on the table for gain or loss, it’s a must to know where investors stand on their bets.
While it’s easy for investors to become caught up with the appealing side of equities, there are other important aspects of the market, like fixed income and interest rates, we should pay attention to.
With that said, direct and inverse relationships can be seen everywhere. Some variables become leading indicators while others tend to lag. And if we follow along closely enough we can capture important changes in trend that tend to impact our portfolio in a meaningful way.
More specifically, I’d like to focus on the general inverse between that of stocks and bonds, and how we could be at an important crossroads – one that will eventually place pressure on equities as interest rates begin a long and steady climb higher.
While you may not realize it today, but these shifts are bound to shake investor psychology to the core going forward.
In theory, stock market prices over the long-term should rise as interest rates fall and vice versa. As such, a low cost of capital environment allows businesses to sink resources into projects they believe will provide an acceptable rate of return and reward shareholders for their vote of confidence in management.
In the graph below, we’ve seen this inverse relationship on full display for quite some time now.
The Federal Reserve’s quantitative easing “zero rate” policy created artificial demand for treasuries, which in turn pushed interest rates so low (5-year 1.49%, 10-year 2.01% and 30-year 2.59% currently) that investors were encouraged to jump ship and dive into stocks. And for investors attempting to maximize returns that exceed the rate of inflation, there are only so many viable options that don’t involve taking on an unwarranted amount of risk.
Sure there were periods of economic bubble bursts (think dot.com, derivatives, etc.) and accompanying volatility, but again, the larger trends remain consistent when it comes to the relationship between interest rates and equity prices.
It is commonly discussed amongst my inner circle of colleagues in the investment research industry how rates have scraped bottom and provide little upside return for those looking to buy traditional bond investments. And allocating even more into dividend-paying equities, most of which have already made a great underlying price run since the recovery of 2009, could lose momentum and hurt portfolios across the board should a correction trigger.
On the flip side, some argue we should be mindful of the possibility that artificially low rates may already be factored into current equity market prices. In other words, a rise in interest rates up to a certain point may have little impact in dragging down major stock market indices.
But there’s good news in all of this…
There seems to be a financial instrument for every type of investor need nowadays. Adjustable “floating rate” investment vehicles, for example, aim to solve the dilemma we currently face where bank certificates of deposit (CD) trap investors in holding longer-term treasuries at unacceptably low rates.
Where traditional bond funds’ performance tends to suffer during a period defined by rising rates, floating rate investments invest in debt whose coupons “adjust” together with interest rates over time. It is important to realize that while you can reduce interest rate risk, you’ll pay for it with regards to the additional credit risk attached.
The iShares Floating Rate Bond (FLOT) is an ultrashort duration investment of high corporate credit quality providing excellent liquidity (635,360 avg. daily volume) to investors. This particular exchange traded fund (ETF) provides a current 0.45% SEC yield and is the standard for those who want to benefit from an anticipated rise in interest rates.
Market Vectors Investment Grade Floating Rate (FLTR) is another ultrashort ETF option for fixed income investors. It provides a slightly lower SEC yield at 0.38% and trades only 30,625 shares daily.
And while you may notice a higher 12-month yield on FLTR we tend to place more weight on SEC data. We do this for a few reasons as it not only includes the coupon payments but changes in bond values as well. Additionally, it will also take into account the reinvestment of those distributions.
Even the U.S. Treasury Department is getting in the game! In early 2014, they auctioned off a two-year floating-rate note. Obviously, this would be a safer route to take. So not only would you be able to minimize risk attached to interest rates but also that of credit as well. Naturally, this would result in lower expected returns. But at the end of the day, you’ll achieve fixed income goals in a flexible way, despite a rising interest rate environment that would normally decimate the standard bond funds which will soon see their easy breezy 30-year profit cycle come to a sobering close.
It’s important to locate funds that are in line with your risk tolerance while providing a historical rate of return consistent with your portfolio objectives. More specifically, you’ll want to keep in mind that some of the riskier funds will invest in corporate borrowers rated below investment grade whose financial condition should be examined further. Hence, with a higher yield, you are likely taking an elevated level of risk.
It would be wise to exercise patience when rates do begin to rise. Coupons attached to floating-rate debt adjust in association with short-term rates (three-month LIBOR) which can lag behind some of the longer-term rate hikes.
P.S. Check out our comprehensive financial newsletter, Reflex Momentum Report. It uncovers “under the radar” investment opportunities, marrying fundamental quality with critically important technical timing to enhance potential returns.