Rates Will Move When the Fed Does

Think all rates would just tick a little higher as the Fed tightens? That isn’t how it works.

It has been so long since the Federal Reserve last raised interest rates that few people probably remember when it happened: June 2006.

Now, although the timing isn’t certain, a Fed rate increase is likely sometime this year, economists believe. And even if the Fed raises rates gradually, higher short-term rates will ripple through the markets and affect a wide range of financial products that are based on market yields, from fixed-income funds to mortgage loans and credit cards.

The impacts will be uneven. Some borrowing costs are likely to rise closely in sync with short-term rates, but others won’t. And people who depend on interest income might not benefit from rising rates for months.

There is still time to get ready, perhaps by reviewing a mutual-fund portfolio, paying down debt or moving to lock in the rate on a loan. Here are ways the Fed’s actions could affect certain investments and financial products:

Effects on bond investments
While any increase in the federal-funds rate—the overnight lending rate used by banks—will quickly nudge yields higher on government-bond maturities as far out as three to five years, yields of longer-term Treasurys might not react as much. That is because long-term U.S. government bond levels are influenced more by developments such as shifting expectations about inflation and strong global demand for yield.

For as long as the Fed’s stimulus continued, investors were forced to own longer maturities to get any return at all. As short rates rise, however, shorter-term debt and even cash eventually will become more attractive versus longer-term bonds, says Gareth Isaac, a senior fixed-income manager at U.K. money manager Schroders PLC.

As some investors shift money out of longer maturities into less-volatile, shorter-term debt securities, selling would push long-term bond prices downward and yields upward, he adds. Bond prices and yields move in opposite directions, so a rise in yields means bonds are losing principal value in the resale market.

Some popular bond strategies might pose more risk than investors realize. One is a big bet on high-yield, or junk, bonds—those issued by companies with lower credit ratings. Because such bonds carry higher default risk, they yield two to three percentage points more than bonds with top credit ratings.

In the past, such bonds have done well despite Fed tightening, as long as the economy and corporate revenues were growing at a decent pace. But Fed stimulus has helped support prices of riskier assets such as high-yield bonds, says Sarah Bush, senior fund analyst at Morningstar Inc. As the Fed pulls away from stimulus, that could hurt high-yield more than in the past.

Another strategy that could prove less effective than in the past is owning a very-short-maturity-bond fund. Although short-maturity bonds are less volatile than longer maturities, their yields are so low that they won’t provide much cushion from rising yields at the short end of the Treasurys market.

For people who want to continue holding some bonds for diversification, Ms. Bush suggests an intermediate-maturity, core bond fund—those that typically own a diverse mix of five- to seven-year maturities. Investors should plan to hold such a fund through an entire rate cycle, she says. Although intermediate funds could lose some principal value if bond yields rise, the impact of that rise would be at least partially offset by the higher interest such funds pay.

Savings rates will trail the Fed…
Although markets influence bank-deposit rates, it is the banks that set the rates. Rates vary because some banks rely more on consumer deposits for funding than others and raise rates only when they want to attract deposits.

Few banks need to do that now, says Ted Peters, a veteran banker and former board member of the Federal Reserve Bank of Philadelphia. “There is a tremendous amount of liquidity in the market, so banks aren’t really hungry for deposits,” he says.

Moreover, he notes, by raising deposit rates more slowly than any rise in short-term market rates, banks can realize bigger profit margins. If short-term rates rose by one percentage point, deposit rates might rise by only 0.40 to 0.60 point, Mr. Peters says.

…As will money-market rates
Although money-market funds must keep weighted average portfolio maturities at 60 days or shorter, it can take several months before they replace all of the securities they own with new ones paying higher yields. That means returns will improve slowly, says David Glocke, principal and portfolio manager for Vanguard Prime Money Market Fund. “The Fed isn’t expected to raise rates aggressively, so income-oriented investors are going to continue to be at a disadvantage for some time yet,” Mr. Glocke says.

Moreover, with investment returns so low in short-term markets, firms that offer money-market funds have been struggling just to cover their own expenses. Even as rates move higher, those firms may be reluctant to immediately pass along all of the added yield they get to fund holders, analysts believe.

Fixed mortgages could hover
Rates for fixed-rate, 30-year-mortgage loans key off the 10-year Treasury yield. So, with most observers predicting 10-year yields will remain fairly stable as the Fed begins to tighten, people with relatively good credit standing should continue to see loan rates near 4% or only a little higher, says Greg McBride, chief financial analyst at Bankrate.com.

The national average 30-year-mortgage rate recently stood just above 4%.

The Fed’s Janet Yellen is expected to hit the button sometime this year.
But home buyers should be wary of adjustable-rate-mortgage loans, Mr. McBride says. The rates on such loans are pegged to a variable rate index, sometimes the London interbank offered rate, or some other rate benchmark that rises or falls along with short-term interest rates generally. The bigger concern, however, is that during the first five to 10 years that you hold an adjustable-rate loan, the rate is artificially low. It’s a teaser rate. Once that initial period ends, the rate automatically adjusts upward—by two percentage points in many cases—regardless of what is happening with short-term rates generally. This can jack up monthly payments significantly.

People should take adjustable-rate mortgages only if they expect to sell a home before the rate is scheduled to adjust upward, Mr. McBride says.

Credit-card choices will narrow
Because short-term rates are so low, credit-card firms commonly have been offering cards with a 0% introductory rate for the first year or so. After that, the rate might jump to 18% or higher.

Once the Fed begins raising rates, those 0% offers could disappear, says Mr. McBride, since the banks’ funding costs will increase as well. Thus it can be advisable to get a 0% card while still available, especially since it allows the cardholder to pay no interest on the balance while he or she pays it down.

People carrying large credit-card balances also can use a 0% card to help pay down a balance transferred from another card. Such cards can provide “a tailwind” toward debt repayment, Mr. McBride says. “The goal should be paying off the balance before the promotional rate expires.”

Michael A. Pollock at Wall Street Journal June 8, 2015