3 SURPRISING INVESTMENTS TO AVOID AS INTEREST RATES RISE
By John Robinson, May 2022

Where NOT to Put Cash

Now that interest rates have begun rising, some consumers are asking if it is a good time to start investing in bond funds and ETFs again. My response is an emphatic NO! While there are many articles highlighting how badly bond funds have fared in 2022, it is important to remember that interest rates have just begun to rise from historic lows. In my opinion, the worst is yet to come. I would not be surprised to see interest rates rising over much of the next decade. With that thought in mind, here are three surprising investments I recommend avoiding (or selling if you own them):

(1) Target Retirement Date Funds
(2) Balanced Funds
(3) Treasury Inflation-Protected Securities Funds

Read over the employee education material provided at any 401(k) plan meeting and you will surely find brochures showing stock mutual funds as “risky” (color-coded in red/orange) and bond mutual funds as “conservative” (color-coded in cool blue).  Indeed, the accompanying historical performance charts likely bear this out by showing the bond funds growing at a fairly modest 5-6% per year with few, if any down years.  The problem with this is that bond fund performance is an artifact of steadily declining interest rates over most of the last 40 years.  What is often overlooked is that the opposite may occur if interest rates steadily rise over a number of years.

Plan participants who expect their “set-it-and-forget-it” target date retirement funds to gradually shift from risky stocks to conservative bonds as the retirement date approaches may be in for an unpleasant surprise upon discovering that the conservative bond funds may be far less stable than anticipated.  To give some perspective, the S&P U.S. Aggregate Bond Index was down 8.61% for the year-to-date through May 20, 2022.  Does that feel like conservative to you?  We expect that type of volatility from stocks, but not from bonds.  Keep in mind too that interest rates have only just begun to rise from the historic lows of the past few years.

The same logic applies to Balanced mutual funds.  These funds, which typically maintain a constant stock: bond allocation of 50-60% stocks: 40-50% bonds, are often regarded as all-weather investments.  When the stock market is soaring, these funds are touted as allowing ample market participation.  When stocks are tanking, the bonds are said to serve as a volatility buffer. Again, that logic largely held true as interest rates were falling, but that stability may be sorely tested in a rising interest rate environment in which both stocks and bonds get battered.

My general advice to investors in Target Date and Balanced mutual funds is to liquidate the positions and divide the portion that was allocated to stocks into stock index funds and the portion that was allocated bonds into 12-month CDs and treasuries.  As rates rise, it may be wise to start laddering the bonds over longer maturities, but, in my opinion, rates have not yet risen enough to resume that popular interest rate hedging strategy.

As for Treasury Inflation Protected Securities (TIPS), one does not need to toss a metaphorical stone very far to hit a finance or econ professor preaching TIPS funds/ETFs as an ideal investment for managing rising inflation.   I disagree, the flawed assumption is that because the principal of the TIPs in the portfolio is adjusted each year in accordance with the CPI, the fund will experience price stability as interest rates rise.  In practice, that does not necessarily happen because the prices of TIPS on any given day do not necessarily reflect actual inflation, but rather future expectations of interest rates and inflation.  To support this point, the S&P TIPS index is down 5.63% for the year-to-date through May 20, 2022.

Although it is beyond the scope of this article, it is worth mentioning that TIPS can also be a tax reporting nightmare in taxable investment accounts.   Instead of TIPS funds, I again recommend keeping the maturities short for now with individual CDs and Treasuries and gradually extending the maturity ladder if rates continue to rise over the next few years.

RELATED READINGS
Friend or Foe? The role of duration in target-date funds (John Hancock Inv. Mgmt)
Look Out for Bond Risk in Target Date Funds (Institutional Invsestor)
Move Over 60:40 Portfolio. You’re Out of Date Now (Barron’s)
Protection for Inflation, With Some Leaks (NY Times)
The Benefits and Risks of Treasury Inflation-Protected Securities (The Balance)

John H. Robinson is the owner/founder of Financial Planning Hawaii, Fee-Only Planning Hawaii, and Paraplanning Hawaii.  He is also a co-founder of fintech software-maker Nest Egg Guru.