After the S&P 500 posted a 19% loss in 2022, economists forecast a recession just over the horizon. Yet, the S&P 500 soared 19% during the first seven months of 2023, peaking in July, before giving up roughly 8% of those gains through October.
The price performance of the bond market was just as volatile when interest rates continued to climb to highs not seen in well over a decade. The rapid rise in interest rates sent bond portfolio values lower.
Financial markets have proven, yet again, that they can be unpredictable. Here are some tips to plan for the years ahead while navigating volatile markets and higher interest rates.
Tax-loss harvesting
The Barclays Aggregate Bond Index has fallen roughly 2% this year through October. If the index fails to recover the loss by year’s end, 2023 will mark the third consecutive year that the index has delivered a negative return.
Historically, bonds have been considered a conservative and somewhat predictable alternative to stocks. However, over the last 39 months, interest rates have pushed higher, and the values of bond portfolios have sunk lower, leaving many investors underwater in their bond portfolios.
However, the losses in fixed income may present an opportunity for investors to sell the assets at a loss in taxable accounts and reinvest the proceeds into investments that have similar features with perhaps longer maturities and higher yields.
The IRS allows taxpayers to offset up to $3,000 of losses against any income, with the balance carried forward and available to offset capital gains in future years. Beware of the wash-sale rule. This IRS regulation disallows the tax loss if investors purchase the same or substantially identical security within 30 days of the sale.
When will rates retreat?
A recent poll of Federal Reserve officials revealed a consensus that a gradual reduction in interest rates could begin by the end of 2024 and into 2025. In this scenario, locking in higher rates with fixed income securities that mature beyond those time frames could prove profitable.
For the first time in over a decade, interest rates on fixed income investments have the potential to outpace inflation. For example, the national average for interest rates on a 60-month certificate of deposit was just 0.75% in April 2021, according to the calculation from the Federal Deposit Insurance Corporation. Inflation for 2021 was reported to be 4.7% for the same year, according to the U.S. Bureau of Labor Statistics. The outsized rise of the cost of living relative to income generated by a CD meant that investors were losing purchasing power in exchange for the safety of their principal. In other words, they were losing money safely.
Fast forward to October 2023. The national average calculated by the FDIC for a 60-month CD is 4.6% and inflation is 3.7% through September. After decades of losing purchasing power, fixed-income securities are generating income that outpaces the current rate of inflation. To put this into perspective, a $500,000, 60-month CD purchased in 2021 would have generated just $3,750 in annual income. Today, that same 60-month CD would generate $23,000 in annual income.
Retirement plans
During market pullbacks, investors should look to maximize tax-advantaged investment accounts. Increasing contributions to employer-sponsored retirement plans, funding traditional individual retirement accounts, Roth IRAs or Roth conversion strategies are all great considerations, particularly for longer-term money. Increasing contributions to retirement plans and leveraging a company match could enable investors to acquire more shares at potentially discounted prices relative to future valuations with tax-favorable outcomes. Acquiring more shares at lower prices could amplify portfolio returns assuming markets recover.
Housing market
Higher interest rates have touched everything, including credit cards, construction projects and mortgage loans. In October, the rate on a 30-year mortgage climbed to 8%, a rate not seen since the year 2000.
Surveys show that some property seekers are waiting for rates to come back down before making a real estate investment. If interest rates retreat and inventory remains low, property values could reflate given the sleeping demand on the sidelines.
Aggressively paying off higher interest rate debt could free up cash flow and credit lines to put investors in a stronger financial standing when the time is right to make a real estate investment.
Shoring up your personal balance sheet now, linking tax planning strategies with investment strategies and planning for the years ahead will add a solid footing to your financial life to help navigate volatile markets with higher interest rates.
Andy Drennen is a certified financial planner and senior portfolio manager at Simmons Private Wealth in Springfield. He can be reached at [email protected].