The Federal Reserve Board just raised the benchmark rate known as the Fed funds rate (the rate banks charge each other to borrow money, usually overnight) by 0.25 percent, the first increase in nearly a decade.
Doesn’t sound like much, does it?
Yet, in anticipation, financial analysts were in a tizzy (MarketWatch’s Markets Editor Mark DeCambre says this may be “the year’s nastiest week for Wall Street“) and the junk-bond market has been reeling.
The Fed funds rate hike is expected to be the first in gradual increases over the next year or so, eventually rising to about 1.4 percent — and perhaps to 3 percent in three years, many experts say. Heather Evans, a Merrill Lynch wealth management adviser in Vienna, Va., says: “Overall, bringing interest rates to a more ‘normal’ level is a sign that the economy is healthy and normalizing.” (Giant caveat: more than half the economists just surveyed by The Wall Street Journal said it was “somewhat or very likely” the Fed funds rate would be back near zero within the next five years.)
Rate hikes, generally speaking, would be good news for savers and some fixed-income investors. They’d be lousy for borrowers, though, who could wind up facing higher rates on credit cards, adjustable-rate mortgages and car loans if rates rise steadily. For example, says Bettermoneyhabits.com, a site from Bank of America and KhanAcademy) the monthly payment on a five-year, $25,000 car loan would be $449 at 3 percent, but $483 at 6 percent. And if adjustable-rate mortgages go up by one percentage point, that could mean a 12 percent increase in a homeowner’s monthly payments.
64 percent of investors surveyed by Wells Fargo thought the Fed should wait to raise rates and 29 percent said a rate hike would be bad for them.
The mixed blessing may explain why 64 percent of investors just surveyed by Wells Fargo said they thought the Fed should wait to raise rates and 29 percent said a rate hike would be bad for them.
Since the Fed funds rate has gone up, with subsequent rate hikes likely to follow, here are eight money moves for savers and investors:
Rising-Rate Money Moves for Savers
The bottom line for savers: Don’t expect much benefit soon from rising rates and do be proactive to get any rewards. “Given the slow pace of expected rate increases, investors in cash alternatives should not expect returns that will offset inflation in the near term,” Brian Rehling, co-head of global fixed income strategy at the Wells Fargo Investment Institute, recently wrote in a report on rising rates.
Shop around online for higher-rate CDs and savings accounts since you likely won’t see much benefit from your local bank. Greg McBride, Bankrate.com’s chief financial analyst, cautioned that a rate hike “isn’t going to mean a whole lot for savers in the short term,” adding that “banks will move even more gradually than the Fed.”
So don’t expect the interest rate on your money-market account or savings account to suddenly shoot up. “People are conditioned to think that when rates go up, rates on CDs will get better. I don’t think they will,” McBride told me. That’s because many banks are flush with deposits; they don’t need to goose savings yields to attract customers.
And if you’re looking for 5 percent CDs anytime soon, forget about it. Rates aren’t likely to rise nearly that much, and 5 percent CDs come with bigger problems for the U.S. economy.
“I hope the days of 5 percent CDs are over,” said Ric Edelman, chairman and CEO of Edelman Financial Services, headquartered in Fairfax, Va., and host of The Truth About Money With Ric Edelman radio show. “The only reason we had them [in the 1980s] was that inflation was 6 percent, and nobody likes high inflation. People tend to recall the good old days when CDs were paying 14 percent in 1981. But mortgage rates were at 18 percent. The good old days were not so good.”
McBride said that once interest rates start rising, however, you’ll generally find the highest savings returns at online banks, community banks and credit unions. “If you sit back and wait for an interest-rate improvement to land in your lap, you’ll be disappointed,” he added.
The most fertile ground, he said, will be among those institutions already paying the most competitive yields. Bankrate.com’s site says the average one-year CD rate is a puny 0.27 percent, but some online banks are paying 1.3 percent. Shopping around for yield is “as close to getting a free lunch as you can get,” said McBride.
Look to online banks, rather than money-market funds, for the highest rates on savings. The funds are even less likely than banks to increase their payouts. Lately, most fund companies and brokerages have been forced to waive expenses to entice money-market fund customers (money-fund fee waivers cost Schwab $166 million in the third quarter, according to The Wall Street Journal). When rates start rising, McBride says, the fund and brokerage firms “can recoup some of those expenses they’ve been eating” — rather than paying out higher yields.
“At a money fund, you can earn .02 percent, but you can earn 1.1 percent in a savings account. It’s not even close,” says McBride.
Before cashing in a bank CD to reinvest in a new one with a higher rate, do the math to see if that’ll really make sense. Odds are, it won’t, due to early-withdrawal penalties. “In a lot of cases, the math will work against you,” said McBride. “To make the math work, rates need to skyrocket.”
Typically, the penalty is three months’ interest for 3- and 6-month CDs; six months’ interest for 1- and 2-year CDs and one year’s interest for 5-year CDs. Worse, some banks assess penalties as a flat percentage of principal and in those cases, cashing out could cost you more than you’ll earn with a new CD. A Bankrate survey found that 89 percent of financial institutions will seize some of the principal if a customer makes an early withdrawal from a CD.
Ladder your CDs rather than trying to time interest rates. Laddering means buying CDs with varying maturity dates; typically, the longer the CD’s term, the higher its rate. That way, if rates do go up, when the shorter-term CDs mature, you can then reinvest in new ones that pay you more.
Rising-Rate Money Moves for Investors
The bottom line for investors: Stick with short- and intermediate-term, high-quality bonds and bond funds and steer clear of junk bonds and junk bond funds.
And remember two rules of bonds:
One, when interest rates rise, bond prices fall. Wells Fargo says an investor in two-year Treasury securities would experience a 1.3 percent negative total return if short-term rates rose 2 percent over the course of 12 months.
Two, the longer a bond’s term (or the terms of the bonds a bond fund owns), the more risk you take when interest rates rise; so short-term and intermediate term bond funds are safer, and smarter to own, when rates are rising, than long-term bond funds.
If you own a bond fund, or plan to invest in one, including in your 401(k), this is the time to really scrutinize its holdings and performance history. “Not all bond funds are created equal,” Joe Jennings, wealth director and senior vp at PNC Wealth Management, said at the MarketWatch panel in New York City I attended a few months back, Rate Quake: How to Manage Retirement Investments in a Rising Rate Environment. “If a bond fund has a long track record, see how it performed in other rising-rate environments.”
Added panelist Michael Falk, a partner at Focus Consulting Group in Long Grove, Ill., and a chief strategist on a global macro hedge fund: “Look at what the fund did in 1994, the last time the Fed made significant moves in a rising-rate environment.”
One key term to look for: duration, which is a measure of a bond’s price sensitivity to changes in interest rates. For example, the price of a bond with a six-year duration will fall about 6 percent if its yield rises by one percentage point. The higher the duration, the more rate-sensitive the bond or bond fund. That’s why, right now, it’s best to go with bond funds whose durations are under seven years.
Stick with short- and intermediate-term bond funds that buy high-quality bonds and stay away from junk-bond funds, which can be at greatest risk as rates rise. Last Friday, junk-bond prices had their largest drop since 2011; hardest hit were those of the kinds of distressed companies owned by troubled Third Avenue Focused Credit Fund, which just closed abruptly and halted investors’ withdrawals, telling them it could take a year or more to be repaid.
All 30 of the biggest high-yield (junk) funds have lost money this year; the average junk bond fund has lost 3 percent.
Credit rater Moody’s Investors Service predicts corporate bond defaults will rise from 2.8 percent this year to 3.8 percent next year. “When interest rates go up, that causes bond ratings to go down,” said Edelman. “A 2 percent rate increase could mean a 20 to 30 percent decline in the value of a junk bond.” His advice for investors: “No junk bonds and no 30-year bonds.”
Plan to hold onto your bond fund for years. Otherwise, if you sell soon after rates have gone up, you could take a loss.
Vanguard recently did an analysis for The Wall Street Journal of a hypothetical intermediate-term bond fund investor, with the assumption that the Fed raises short-term rates by 0.25 percent quarterly — 2 points altogether through July 2019. The investor would lose money next year, but generate positive yearly returns after that because the fund manager would be buying bonds with the higher rates.
If you plan to buy individual bonds, go with a laddering strategy like the one for CDs mentioned earlier, to take advantage of rising rates. That means, as MarketWatch’s Elizabeth O’Brien recently wrote, buying bonds maturing in, say, two years, four years and 10 years. This way, when the short-term bonds mature, you can roll over your proceeds into longer-term bonds.
“It’s hard to come up with somebody where laddering wouldn’t be helpful,” Kathy Jones, chief fixed income strategist at Schwab Center for Financial Research, said at the MarketWatch panel.
But, Jones added, if you’ll be buying bonds, be sure you diversify among issuers when you ladder, to spread out your risk. “You don’t want all your bonds from the same municipality, for example,” she said. “Things happen. Detroit. Puerto Rico. In general, we think for ladders, you should stay with investment-grade corporate bonds and Treasuries.”
That way, you won’t fall off your ladder.