How Will Rising Rates Affect Mutual Funds?

The Federal Reserve is widely expected to hike interest rates on December 16, which could have a profound impact on the financial markets. Since the 2008 financial crisis, U.S. interest rates have hovered near zero percent as the central bank tried to ignite economic growth and increase inflation to its 2% target rate. The rate hike comes amid improvements in the U.S. economy and in contrast to Europe’s still-dovish monetary policy.

In this article, we’ll take a look at how rising interest rates may affect mutual funds and some potential opportunities.

Interest Rates on the Rise

Interest rates have a number of effects on the real economy and financial markets. In general, rising interest rates are designed to contain future inflation and keep asset valuations in check by making it more expensive to borrow money. A decrease in interest rates is designed to increase inflation and stimulate the economy by making it cheaper to borrow money. While interest rates are only one of many monetary policy tools, they are among the most powerful.

After the Fed’s maintaining of near-zero interest rates for the last seven years, Federal Reserve Chairwoman Janet Yellen told Congress in early December that domestic economic conditions were sufficiently strong to start raising interest rates later this month. Many experts believe that the central bank is likely to follow through on hiking interest rates, but the pace of interest rate hikes moving forward may depend on global economic conditions.

Worst-Affected Funds

Rising interest rates tend to have the biggest effect on debt instruments since they are highly sensitive to changes in interest rates. For example, rising interest rates will typically reduce bond prices in order to increase yields and effectively compete for capital.

Mutual funds that hold long-term bonds may be the most susceptible to rising interest rates since prices may head lower as interest rates rise. For instance, the highly rated Vanguard Long-term Corporate Bond Index Admiral Shares (VLTCX) has fallen 3.13% so far this year after gaining 16.72% in 2014, due to the prospects of rising interest rates. The fund may experience further declines if interest rates continue to rise at a higher-than-expected pace.

Short-term bond and high-yield (junk) bond mutual funds tend to perform slightly better as investors shift assets from long-term, low-yield bonds into these instruments. While they are adversely affected by rising rates, the fund flows can help increase demand and offset the price declines seen in other fixed-income asset classes. Municipal bond mutual funds may also experience less of a decline given their tax-advantaged nature.

Potential Opportunities

Rising interest rates may negatively affect mutual funds that hold bonds as well as broad equity funds in some cases. But, there are some mutual funds that may be positioned to benefit from higher interest rates. Cyclical equities, financial equities, and floating-rate bonds tend to be strong performers during these periods because they benefit from higher rates. For example, financial firms may realize greater profits from a higher interest rate spread.

Here are some mutual funds to consider in these areas:

• Cyclical Equities: Fidelity Select Retailing Portfolio (FSRPX)
• Financial Equities: Mutual Fund Services Fund (TFSIX)
• Floating-Rate Bonds: Fidelity Floating Rate High Income Fund (FFRHX)

There’s no guarantee that these funds will be strong performers during a period of high interest rates, but there’s historical and anecdotal evidence that they tend to do well. Investors may want to consider them as part of a diversified portfolio or consider investing in a broad market index mutual fund that provides exposure across many asset classes.

The Bottom Line

Rising interest rates will likely have a negative impact on the financial markets since the cost of borrowing has increased. While most funds will experience some declines, which may already be priced in, bond funds may have the most to lose from rising rates. The good news is that there are some sectors that may actually benefit from rising interest rates that investors may want to consider as part of a diversified portfolio.