Conversely, managers who know the difference between the debt profiles of stable Ann Arbor, Mich., and Detroit may find hidden diamonds for their clients.
A rate rise may also provide a teaching moment, advisors said. “We need to remind all clients about the basics of bond math,” said Leo P. Grohowski, chief investment officer and executive vice president at BNY Mellon Wealth Management. “A 2 percent rise in a low interest rate environment feels OK,” he said. “But when interest rates are this low, it doesn't take much of a backup in interest rates to cause a more significant erosion of principal.”
A solid single A-rated muni bond with a good 10-year credit outlook, however, will provide a higher yield than a 2.1 percent Treasury note—and unlike the note, the muni is tax-free, said Grohowski. Despite expecting more downgrades than upgrades, he would not avoid the asset class. “It just puts a premium on due diligence,” he said.
BNY Mellon is thinking past September to 12 and 18 months out—the period required to make its asset allocation decisions. In that period, the firm expects treasury bonds to be in “a coupon-minus return structure,” said Grohowski. During the bond bull market, investors have enjoyed a coupon plus principal appreciation caused by dropping interest rates. In fact, said Grohowski, "purchasing a 10-year U.S. Treasury note today at a yield just over 2 percent would actually produce a total rate of return approximately -3 percent if interest rates increase by 1 percent over the next 12 to 18 months."
Other securities, including equities, have some bond characteristics and could be negatively impacted by rate rises in the next year or two. Utility stocks could find their dividend growth challenged, Grohowski said, because utilities have to reinvest in themselves.
REITs, due to linkage to commercial mortgage backed securities and preferred stock, are sensitive to interest rates on mortgages. Master limited partnerships, “an area where high net worth investors have been active,” could experience a “double whammy” if rates rise and energy prices stay low, Grohowski said.