The discussion among investors when considering an interest rate increase by the Federal Reserve (“Fed”) typically centers around the impact of the rate increase on the stock market, not the bond market.  When interest rates do rise, it may or may not have an impact on the stock market.  The impact of a rate increase on a bond portfolio is easy to determine.

The effect of a rate increase on the stock market depends on why the Fed is raising rates.  Most of the time, the Fed raises rates because the economy is growing too rapidly.  In the case of an expanding economy, company earnings might grow more rapidly than the increased cost of borrowing money and it may not hurt the stock market because earnings are solid and rising.  However, if the Fed were to raise interest rates in the current economy, it is more likely stocks would fall.  This is so because the economy is not growing rapidly and corporate earnings are falling and such an increase would exacerbate the fall in earnings.  This is especially true for those companies that have borrowed money to increase dividends and share buybacks (mainly large US companies) over the past several years.

For bonds, it is simple math to determine how an interest rate increase will impact your portfolio.  It is common sense that your bond price will fall.  Why?  If one can buy a similar bond that pays a higher rate of interest, you must sell your bond at a lower price so that the investor gets the same return.  Below is a chart showing the impact on the price of a US Treasury bond at various rate increases.  As you can see, if interest rates increase by 1%, a 10-year Treasury Note would drop 8.8% in value while a 30-year Treasury Note would drop a whopping 19.3% in value.  Investors that extend the maturity of bonds in a rising interest rate environment are increasing the risk in their portfolios.

So what does this mean for your portfolio?

THOR is “risk off” relative to our clients’ fixed income portfolios and we believe that capital preservation is of utmost concern.  We believe we have reduced the risk of rising interest rates by lowering the average maturity of our clients’ fixed income securities and diversifying in non-traditional investments.   Those non-traditional investments include a non-traded, high quality real estate investment trust and Business Development Corporations (Please read our market update on September 1st explaining why we like Business Development Corporations).  On the equity side, we are underweight equities as a whole and continue to have our lowest exposure to large US companies, whose earnings will suffer more when interest rates rise for the reasons listed above.