Impact of Rising Interest Rates
Interest rates have been in the news recently. Whether it is the Federal Reserve increasing rates for the first time in three years, treasury yields increasing, or talk about the national deficit, it has been hard to ignore the recent attention interest rates have received. This article looks at the main drivers of higher interest rates, the impact it may have on your portfolio, and how TIAA Traditional may serve as a fixed income diversifier in this environment.
Many of you will recall the 40-year period from the 1980s to 2020 when interest rates continued to decrease. This led to a long-lasting bull run for bonds. Since the interest rate lows in March 2020, rates have increased steadily. The 10-year treasury rate bottomed out at under 0.5% and has recently reached over 5%, a new high over the last 19 years. The last six years have brought a different environment.
There are several reasons interest rates have increased this year. One of these reasons is the continued conflict with Iran. Oil prices spiked when the conflict began in February and after a brief pullback over the summer, have climbed back above $100 per barrel as the conflict drags on. This sustained rise in oil prices has contributed to higher than typical inflation. The Federal Reserve weighs two main factors when setting the Federal Funds Rate, and inflation is one of them. As inflation rises, the Fed is more likely to raise short-term interest rates to help bring it back down.
Another reason that rates have risen is the growing national debt. The U.S. debt hit $40 trillion just over a month ago for the first time ever. Significant annual budget deficits continue to add pressure to this debt total, likely driving it even higher in the coming years. Increased issuance of government debt to fund these deficits could lead to higher interest rates if the demand for the debt doesn’t keep up. As rates rise, new demand for bonds is likely to emerge, but the question is how much further rates need to climb to attract those buyers.
Interest rates and bond prices have an inverse relationship. As rates go up, the value of your bonds falls. Consider the following example. If you purchase a 10-year treasury bond at 4%, that bond will pay you 4% each year for 10 years if you hold it to maturity. If rates increase and you can now buy a 10-year bond for 5%, your bond becomes less valuable. Anyone can purchase a 5% bond on the open market, so if you had to sell your 4% bond before maturity, investors aren’t willing to pay the full price you initially paid. This is known as interest rate risk.
One asset available to most professors is TIAA Traditional, a fixed annuity within TIAA 403(b) plans. It provides you with a contractual minimum guaranteed interest rate, subject to the terms of the applicable contract and TIAA’s claims-paying ability. Unlike a certificate of deposit at a bank, TIAA Traditional is an annuity product and is not FDIC insured. Its liquidity, withdrawal, and distribution provisions may vary by contract.
In this period of rising interest rates, having an allocation to TIAA Traditional as part of your portfolio’s fixed income may have been beneficial. It helped reduce interest rate risk within the fixed income portion of the portfolio, since it doesn’t decline in value the way bonds do. 2022 was a prime example. The Federal Funds Rate increased rapidly to combat significant inflation which negatively affected bond prices. TIAA Traditional operates differently from marketable bonds, and its contractual crediting features may result in different performance characteristics during periods of rising rates. Retirees who needed to draw income from their portfolio in 2022 may have been able to use TIAA Traditional as a source of retirement distributions rather than selling other investments during a market decline.
Another benefit is that TIAA periodically adjusts the rate offered on new contributions. If TIAA raises the rate as interest rates rise, you may be able to lock in that higher rate. There are specific rules to keep in mind when navigating this process to qualify your funds as “new money” to receive the higher rates. This process can also negatively impact your annuity payout if you are intending to annuitize these assets in the future. You should discuss these trade-offs with a financial advisor.
The last six years have been tough for bond investors. That said, investing in bonds now is much more attractive than it was when rates were lower. If rates stay the same, you are getting a higher coupon rate. If rates go up, today’s higher starting yields may provide more income to help offset some of the negative price impact associated with rising rates, although bond values can still decline. If rates decrease, you may get the benefit of price appreciation for bonds. If you are managing your portfolio to a certain stock and fixed income percentage, changing market conditions may provide an opportunity to review whether rebalancing is appropriate based on your individual objectives, risk tolerance, time horizon, and financial circumstances. If you have held TIAA Traditional throughout the last six years, you may also want to evaluate whether your current allocation between TIAA Traditional and marketable bonds continues to align with your retirement objectives.
Higher interest rates have created challenges recently but now create different opportunities for fixed income investors than were available when rates were substantially lower. With rates at their highest levels in years, this may be a good time to revisit your retirement plan and evaluate whether your portfolio remains aligned with your long-term goals, risk tolerance, and income needs.
Savant University Wealth Management (“Savant”) is an SEC registered investment adviser headquartered in Rockford, Illinois, serving clients in academia nationally. Our advisers have specific and in-depth knowledge about university employee benefit programs and retirement plans. We work with university faculty, physicians, and other professionals. We are not associated with any university, or any retirement vendor and we have no access to your private retirement or personnel information. Past performance is not indicative of future results. Different types of investments involve varying degrees of risk. A copy of our current written disclosure Brochure discussing our advisory services and fees is available upon request or at www.savantwealth.com.
Zachary D. Meulemans
Financial Advisor
CFP®, ChFC®