The Federal Reserve is weighing a reduction in bond purchases (Quantitative Easing) in the near future which will reduce the growth of the money supply. It’s widely expected that this action will lead to interest rate increases that should have an impact on the value of fixed income securities that private investors could be holding. Bonds, notes and other fixed instruments of all kinds face a decline in value as new issues are released with higher interest rates. But will those investors who have income-based equity investments in their portfolios also have to watch out for declining values?
How the Fed changes interest rates: The Federal Reserve does not literally establish changes to market rates of interest. Instead, it lifts (or lowers) the target rate for Fed Funds, or monies loaned by the Fed to commercial banks. The banks then loan these funds to consumers, either business or personal, charging a higher rate of interest that maintains their spread. When the Fed Funds rate increases, does this automatically mean increased interest rates from banks? Not necessarily. Like most prices in the marketplace, interest rates also have a market behavior. Banks that have a large supply of money to lend before the Fed Funds rates go up might still offer lower rates or discounts to their customers. Those banks that must use Fed Funds for new business could be obliged to match these discounted rates thereby reducing their own spreads. Rising rates are felt first by lenders who acquire capital from either the Fed or money markets and cannot pass that cost along to end users.
How fixed securities are impacted: Fixed yields move inversely to prices as the return is established by a contract and won’t change even if the fixed instrument’s price does change. Current yields (the amount of return divided by the current price), will climb as the price of the instrument falls, and vice-versa if the price climbs. When the Fed raises its targets on Fed Funds, the supply of money going to the banks will likely decrease. This, in turn, will likely force interest rates to climb across the board as long as the demand for money does not also decrease at the same time. New debt securities will be issued with higher interest rates, and investors will be more likely to buy these newer issues if they are in the same risk category. The demand then declines for the older securities, and their value will fall.
Impact to other income-based securities: Preferred stock behaves much like a fixed instrument in that the dividends are set by a contract. Investors should expect a similar impact to preferred shares when interest rates rise as the preferred prices will similarly decline. Business Development Corporations (BDC’s) might also find declining values when interest rates increase as their business models have them borrowing from money markets and lending to corporate entities who cannot borrow in the money markets themselves. The higher cost of capital to BDC’s cannot always be passed on to their customers, and would be absorbed by the BDC. Eventually, this action could impact the BDC’s own income and ability to pay dividends to its shareholders. Real estate investment trusts (REIT’s) and Master Limited Partnerships (MLP’s) that also pay large dividends might similarly be impacted.
Impact to income-based common stocks: Common stocks should not be impacted by rising interest rates as any influence from rising rates will be priced in to most corporate common stock dividend decisions. In theory, higher rates lift the required returns on all equities, which end up reducing the present value of future cash flows that are often used as a basis for a common stock’s valuation. These same cash flows may also be impinged by higher interest expenses owing to rate hikes. The impact to dividend paying stocks should be neutral from a rise in interest rates without mitigating circumstances. But valuations are important, and mitigating circumstances often occur. Income-focused investors might deal with the idea of selling dividend paying equities to buy fixed securities instead.
Conclusions: Private investors who focus on income need to be vigilant about how interest rate increases might impact some of their fixed income securities. But there is no need to proactively restructure portfolio equity sections for potential value declines without first observing a negative impact on dividends from interest rate increases. Timing can be crucial. The Fed ordinarily makes its intentions known far enough in advance for investors to apply changes to their portfolios without great loss of capital.
Sources: Morningstar Dividend Investor, October, 2015, Vol. 11 No. 9.
David, I remember when a passbook savings account paid 4% year end and year out. Many people who have depended on CD’s paying above 2% for most of their non-social security income have suffered with the near zero interest income now. Won’t some benefit with the increase in rates?