My brother-in-law is in the lending business and at both our Thanksgiving seudah and family Chanukah get-together, I heard him discussing how great it is that rates are falling. I understand that falling rates may be good for his business of lending money. It means more people will want to borrow if rates are lower. However, what about the average person like me who isn’t looking to borrow money? I’m approaching retirement, have a decent nest egg, and I keep seeing my CD and money market yields fall. My question is whether I should be concerned with rates falling or as excited as my brother-in-law.
Your question is timely, since many soon-to-be retirees are in the same predicament.
For context, the federal funds rate, which is the rate to which your brother-in-law is referring, is the lending rate that banks use when they borrow money from one another. It impacts credit card rates, mortgages, car loans, savings account yields, the borrowing costs businesses pay, and more. In many ways, lower rates are positive for consumers.
However, many investors may not see falling rates as positive given some of the impacts you alluded to, namely lower yields on CDs and money market funds. Unfortunately, in order to compensate, many investors are tempted by options that promise higher yields and end up taking far more risk within their portfolios.
During every falling interest rate environment, I’ve noticed investors making the same mistakes and missing out on certain opportunities. Investors who are aware of the financial options available will be best equipped to get through this part of the interest rate cycle unscathed and potentially even improve their financial situation. Below are some points to consider.
DO refinance onerous debt: Lower interest rates make borrowing cheaper, so it may be a good time to refinance high‑interest debt such as mortgages, auto loans, or personal loans. This can significantly reduce monthly payments and the total interest paid over time. You can also consider consolidating multiple high‑interest debts, like credit card balances, into a single loan with a more favorable rate. This will save money while also simplifying payments. Falling rates often stimulate the housing market as well. If you’re thinking about buying a home, lower mortgage rates can increase affordability. Keep in mind that while lower mortgage rates may make monthly payments lower, they also tend to cause real estate prices to rise. Be sure to run the numbers so you are purchasing a home that is within your means.
DO have exposure to stocks: Lower borrowing costs for businesses can increase economic growth and boost corporate earnings, which generally benefits the stock market. It’s important for all retirees to have proper exposure to the stock market. This is especially true when rates are falling, which may serve as a tailwind to this part of your portfolio.
AVOID reaching for yield: Over the past few years, investors have enjoyed putting their cash in money market funds and collecting attractive yields with virtually no risk. However, as rates come down, these risk-free rates will also fall. While searching for higher yielding investments, investors may subject their money to volatility and possibly the loss of principal.
Focusing on the yield of an investment at the expense of all other due diligence will have an unfortunate ripple effect on the rest of one’s finances. Money that folks need for near-term expenses or a rainy-day fund should still sit in cash or cash equivalents despite a more modest yield.
AVOID pursuing lower quality credit: Investors may be enticed by lower quality credit to maintain a certain yield within their fixed-income allocation. Unfortunately, that means investing in companies with shakier balance sheets. This may be fine for a small portion of one’s portfolio. However, substituting most of your fixed income to obtain a higher yield is ill-advised.
As I frequently remind my clients, risk and return are inextricably linked. If you want higher yields in a low-interest-rate environment, you need to be willing to take more risk with your capital. It’s important to keep in mind that the ultimate role of high-quality bonds in one’s portfolio is to serve as a ballast against more volatile equity positions. Once you invest in lower quality companies, those diversification benefits, and the margin of safety, are gone.
AVOID extending duration: Another way for investors to maintain a targeted yield within their portfolios is by extending the duration on their fixed-income holdings. In other words, instead of going out one or two years on the yield curve, they instead go out one to two decades or longer.
The challenge is that duration is a measure of a bond’s price sensitivity to interest-rate changes, expressed in years. Therefore, a bond with a higher duration is more sensitive to interest-rate fluctuations. Its price will change more significantly for a given change in interest rates than the price of a lower duration bond. For example, a bond with a 10-year duration is expected to lose approximately 10% of its value if interest rates rise by 1%, whereas a short-duration bond would be expected to lose only about 1% of its value.
Granted, we are in a falling rate environment, but any unexpected change to interest-rate policy can leave bond investments just as volatile as equities. Extending duration on your bonds leads to more portfolio volatility without the upside that equities provide.
Stay focused on what matters: To avoid common missteps in a falling rate environment, I encourage my clients to take a step back and look at the bigger picture. Instead of focusing on the Federal Reserve or what your brother-in-law is saying, investors should instead focus on the factors that should always determine their portfolio allocation. This includes one’s time horizon, risk tolerance, and goals.
For example, if you need the funds within a few years, then using a savings account, money-market fund, or short-term CDs will always make sense regardless of the drop in yields. Investors should not risk the money they need for near-term expenses to get a higher yield.
If an investor is approaching retirement, like you are, having some money in cash equivalents and high-quality bonds for a couple of years’ worth of expenses makes sense. However, it also makes sense to have exposure to stocks to grow your portfolio over time to combat inflation and help ensure that you don’t outlive your funds. Where rates are, and whether they will drop further, are immaterial to this reality.
Staying focused on yourself and your goals instead of the latest headlines and what others are doing is always the best approach when it comes to one’s finances.