As the Fed starts to lift its foot off the gas pedal, it may be time to ditch beloved, high-income sectors such as utilities and telecommunications in favor of stocks that can better ride the economic recovery.
Janet Yellen, right, has been approved by the Senate and will succeed Ben Bernanke as Federal Reserve chair Feb. 1.
And so a new era begins.
As interest rates rise, investors need to take a hard look at portfolios that were designed to hold up when yields were on the decline and safety was in high demand.
It may be time to ditch beloved high-income sectors, such as utilities and telecommunications, in favor of those in which companies can increase earnings more quickly as the economy picks up steam. Commodities, which often suffer as interest rates rise, will be a tricky bet. Home values haven't been as hurt by higher mortgage rates as you might expect.
In fixed income, investors should stay away from Treasurys and mortgage bonds -- the securities most directly affected by the end of the Federal Reserve asset-buying program designed to juice the economy -- and look for deals among municipal bonds that have been punished by default fears. Resist the temptation to load up on short-term debt.
Interest rates have been heading steadily down for more than three decades, but last year the rate on the benchmark 10-year Treasury climbed 1.27 percentage points to 3.03 percent, ending a three-year streak of declines and prompting investors such as Pacific Investment Management Co.'s Bill Gross to predict that the long bull market for bonds has ended. The rise in rates stuck investors in funds that track the Barclays U.S. Aggregate Bond Index with their first loss since 1999 -- albeit one of only 2 percent.
It's important not to overreact. "Some investors have concluded that there's a 30-year bear market in front of us," says Kathy Jones, vice president and fixed-income strategist at the Schwab Center for Financial Research, a division of San Francisco-based brokerage Charles Schwab (SCHW). "It's more likely that we just see a small, gradual rise in rates."
It is possible that interest rates won't rise much further than they have already. Since 2000, 10-year Treasury yields have tended to settle about 0.7 percentage point below economic growth before adjusting for inflation, Jones says.
At current growth levels, that suggests the natural rate for Treasurys would be somewhere between 3 and 3.5 percent -- not much higher than it is now.
There also isn't any rule that bond rates can't stay low for prolonged periods. Japanese 10-year government bonds have had a yield of less than 3 percent for well over a decade.
As bond rates dropped between 2010 and 2013, yield-hungry investors snapped up anything that could give them more income, including stocks of utility and telecommunications companies and real-estate investment trusts.
Yet in 2013, those stocks performed the worst relative to the broad market. A typical S&P 500 ($INX) exchange-traded fund rose 32 percent in 2013. But the Utilities Select Sector SPDR (XLU) climbed just 13 percent. The iShares Global Telecom ETF (IXP) gained 24 percent.
This year, if rates continue to rise, investors should expect these sectors to continue to underperform, says Alec Young, global equity strategist at S&P Capital IQ.
"The question is: How big a deal was the yield when someone bought one of these stocks?" Young says. Those stocks will continue to perform poorly, he says.
Investors should lean toward economically sensitive sectors, such as consumer-discretionary companies -- which sell items such as automobiles -- energy and financial stocks.
Those last three sectors have the added advantage of being relatively cheap. As of Jan. 3, the price-to-earnings ratio of the S&P 500, based on the past 12 months of earnings, is about 16.7, according to FactSet, compared with P/Es of 16, 13.9 and 14.2 for consumer discretionary, energy and financials, respectively.
It is easy to get exposure to such sectors with ETFs such as the Vanguard Energy ETF (VDE), which charges annual fees of 0.14 percent, or $14 per $10,000 invested. The Vanguard Consumer Discretionary ETF (VCR) costs 0.14 percent, while the Financial Select Sector SPDR (XLF) costs 0.18 percent.
Emerging-market stocks and bonds might have a lot to lose as the Fed unwinds its stimulus programs and, eventually, starts to raise short-term interest rates, says Ed Yardeni, president of Yardeni Research, an investment-strategy consultancy in Brookville, N.Y.
Many investors looked to emerging markets for income. If U.S. bonds, which are much less risky, start offering higher yields, Yardeni expects that investors will move back in that direction.
Research from Harvard Kennedy School of Government professor Jeffrey Frankel has found that commodities also tend to suffer when inflation-adjusted interest rates rise.
That is because as rates rise, the incentive to extract and the cost of storing commodities also goes up, and investors look for better returns elsewhere, Frankel says.
To be sure, though commodity prices historically have suffered when intermediate and long-term rates rise, they are more affected when short-term rates climb, he says, something that might not happen for years.
"It's quite possible that after 30 years of a downward trend in interest rates, we could see them move upward in coming years and that could result in sending real commodity prices down," he says.
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