Investment and Financial Planning Considerations in Higher Interest Rate World
The interest rate on the 10-year U.S. Treasury has risen from less than 1% in 2020 to almost 5% today. As a result, mortgage rates, corporate bond rates and perhaps the less known IRS 7520 rate are at generational highs. The latter is used for estate planning and tax calculations. The ability to earn real returns (returns more than inflation) in lower risk bond markets has been absent in financial markets since the early 2000s. Like the great financial crisis, and the ensuing decade of extraordinarily low interest rates, higher rates represent a generational shift in financial markets. This should also represent a shift in investment portfolios and financial plans. Investors should be thinking about:
Adjusting their investment allocation between stocks, bonds, real assets, and other types of assets.
Wealth transfer opportunities created by higher rates
Re-Thinking Investments and Asset Allocation
Since 2009, interest rates have been low, and most investors have earned returns primarily by investing in stocks. That includes private equity and venture capital funds that benefitted from a low cost of financing and low long-term discount rates for future earnings. In fact, investors needed to take on outsized equity positions because lower risk bonds and money market funds were barely earning returns over inflation. The result is that many investors took on more equity risk in their portfolios than they initially desired to achieve their long-term return goals. Now that rates have reset higher, investors may be able to take on less risk by adding bonds to their portfolio while still earning sufficient returns.
From 2009 through 2019, the 7-Year Treasury yield averaged just 2.12%. The 7-year bond yield started at 1.87% and ended the period at 1.83%. So, from 2009 through 2019, yields moved up and down, but capital gains were minimal, and investors simply collected their interest payments each year. That means that to earn the 8% forecasted in many financial plans, investors needed to allocate over 70% of their portfolio to stocks or other assets to earn a total 8% return each year.
Fast forward to today, the 7-year Treasury yields 4.88%. That means the portfolio only needs another 3.12% in return to reach its 8% target. That 3.12% can be achieved with only a 39% allocation to assets besides the intermediate 7-year U.S. Treasury. Investors can use lower risk treasury bonds for more than half of their required return and only depend on more volatile assets for the remainder.
This is a simplified example and different interest rate benchmarks will produce slightly different results as will different assumptions about returns; but the overall conclusion is the same regardless of the specifics of the illustration. Investors should be thinking about reducing risk and increasing their bond investments.
Using Higher Interest Rates to Reduce taxes on Wealth Transfer and Estates
Because interest rates are higher, asset prices are lower and wealth transfer opportunities are created. While you may be optimistic about your real estate or business holdings, they are theoretically worth less today than two years ago. That means that you can transfer those assets to your heirs at lower values with reduced estate tax implications. Thematically, higher rates mean that you should consider transferring more assets, more quickly.
For real estate holdings, a Qualified Personal Residence Trust (QPRT) is one option to consider. A QPRT can be used to transfer ownership of the real estate to the next generation while you continue to use the property for your lifetime. The value of the property is discounted using the IRS 7520 rate to account for the time you will continue to live in the home. The higher the interest rate, the lower the applicable valuation for estate and transfer tax purposes.
Charitable “Split Interest” Trusts are often used to minimize taxes while transferring assets to heirs and to philanthropic organizations. These trusts are called “split interest” trusts because your heirs receive either the current income and dividends from the assets, or the remaining assets in the trust at the end of the trust’s life, but not both. The charity receives the other interest. During the low-rate environment, giving the current income to charity and passing the remaining assets to your heirs maximized the charitable tax deduction. Now the opposite is true, giving the current income to your heirs and the remainder to charity maximizes the charitable tax deduction. If you have a taxable estate and are planning to give assets both to charity and to your family, reconsidering split interest trusts while rates are high may be worthwhile.