How to Prepare for Rising Interest Rate

<Image credit to CNBC.com>

So, it is final that FED increased interest rate by 25 basis points on last Wednesday and you could easily find news and comments on the impact of stocks and economy with this rate hike.  But at least the rate hike is seen as a vote of confidence in the US economy which has witness increasing inflation and job growth and of course the market react positively on this.

Our immediate thinking will be, of course, the cost of borrowing will increase as the bank will price in higher loan rate and this lead me to think further that will bank be benefited with higher loan cost eventually. Meantime, some analyst are more cautious on that because our banks are facing loan crisis from O&G sector hence may not be so sanguine on bank’s future earning.

Some are more optimistic about “ Consumer discretionary goods “ related stocks as the better job market and income growth may lead to more spending on these items. But in Singapore, with the worsening job market and declining consumer spending, we may have different situation as the US. Well, one may need to pull out their crystal ball to see which sectors might be affected or benefited under such a rising rate environment.

While searching for clues on how to do and cope with the rising interest rate environment, I came across this so-called “ Bond Ladder “ strategy as a way to minimize the interest rate risk and increase liquidity in a shorter period.

Concept Explained by Investopedia :

What is a "Bond Ladder "

A bond ladder is a portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of purchasing several smaller bonds with different maturity dates rather than one large bond with a single maturity date is to minimize interest-rate risk, increase liquidity and diversify credit risk.

BREAKING DOWN 'Bond Ladder'

In a bond ladder, the bonds' maturity dates are evenly spaced across several months or several years so that the proceeds are reinvested at regular intervals as the bonds mature. The more liquidity an investor needs, the closer together his bond maturities should be.

Why Use a Bond Ladder?

Investors who purchase bonds usually buy them as a conservative way to produce income. However, investors looking for a higher yield, without reducing the credit quality, usually need to purchase a bond with a longer maturity. Doing so exposes the investor to three types of risk: interest rate risk, credit risk and liquidity risk.

When interest rates increase, bond prices react inversely. This especially holds true the longer the maturity date is on a bond. A bond that matures in 10 years fluctuates less in price than a bond that matures in 30 years. If the investor needs some funds before the bond’s maturity, the rise in interest rates causes a lower price for the bond on the open market.

When interest rates rise, the demand for lower interest-paying bonds decreases. This leaves the bond with less liquidity since bond buyers can find similar maturity bonds with higher interest payments. The only way to get a more favourable price in this scenario is to wait for interest rates to go down, which causes the bond to go back up in price.

Buying a large position in one bond could also leave the investor exposed to credit risk. Similar to owning only one stock in a portfolio, a bond’s price is dependent on the credit of the underlying company or institution. If anything lowers the credit quality of the bonds, the price is negatively impacted immediately. For example, Puerto Rico bonds were once very popular, but when the province had financial issues, the bond prices immediately plummeted.

Using a bond ladder satisfies these issues. Since there are several bonds with a staggered maturity, bonds are constantly maturing and being reinvested in the current interest rate environment. If the investor needs liquidity, selling the shorter maturity bonds offers the most favourable pricing. Since there are several different bond issues, the credit risk is spread across the portfolio and properly diversified. If one of the bonds has a downgrade in credit quality, only a portion of the entire ladder is affected.

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While many may argue that “ This Time is Different “, the new technology revolution is taking place, concepts and “buzzwords “ like “ Blockchain “ (here from Wikipedia ), “IOT: Internet of Things “( here ), “ BIG Data analysis “ (here ), "Quantum Computing "(here), “ Cyber Security “, "Virtual Assistant ", "Augmented Virtual Reality", “Smart Nation “ etc are being quoted in news from mainstream media rampantly.

Yes, the stock market may still in an upward trend for a very long time as nobody really knows when the music will stop and all the “animal spirit “ may suddenly disappear as what I have written in my previous blog. (here ) Many ways to determine the market valuation and one of it is to look at the long term mean regression.

While Singapore market is at long term mean level (not expensive but not cheap as well ) but the other advance market is in the higher end of the mean level. As such, I opt for a more conservative approach to increase my cash and short term fund/bond from my dividend income and stay invested with a “cautiously optimistic “ point of view.

Cheers !!

PS “How to Prepare for Rising Interest Rate “ full article from Investopedia (here)

Quote Of The Day :

“ We fail to appreciate the great power of regression to the mean “ by Charles D Ellis (in his book: Winning The Loser’s GAME )