With Rates at 2008 Highs, Wealthy Investors Are Making 5 Key Shifts
Long-term borrowing costs are the highest they’ve been in 18 years, according to Reuters. This matters because high rates can create significant ripple effects. Higher borrowing costs make it harder for consumers to finance homes, autos and other purchases.
Meanwhile, corporations have to either absorb the additional costs or pass them on to consumers, potentially resulting in fewer sales. And stock and bond prices often drop in response to higher rates, decreasing portfolio values.
To protect their wealth, high-net-worth investors focus on four main areas: taxes, inflation, liquidity and downside risk. Rather than panicking and selling in an unfavorable environment, the ultra-rich follow a plan designed to preserve principal.
Here are five moves wealthy investors and aspiring wealth builders alike are considering in this high-inflation, high-rate environment.
1. Building Short-Term Treasury and Cash Ladders
One way to avoid the volatility and risk of holding long-term bonds is to keep money in cash and short-term Treasuries. While you won’t earn quite as much income, your principal will be much safer.
If you own a 2-year Treasury, for example, its value will drop by about 4.7% if market interest rates rise by 1%. However, if you own a 30-year Treasury, that drop will exceed 20%, according to the Hartford Funds.
2. Moving Toward Tax-Exempt Municipal Bonds
As yields rise, municipal bonds become more attractive to investors in high tax brackets. Municipal bonds pay interest that is exempt from federal income tax, and in many cases from state tax, as well.
Municipal bonds are often quoted in terms of their "taxable-equivalanet yield" to make them easier to compare with Treasuries or corporate bonds. An investor in the 37% tax bracket only earns a net after-tax yield of 3.15% on a 5% taxable bond, for example — a rate that many municipal bonds can beat. And that’s without factoring in any state tax benefits.
Many municipal bonds are also insured, making them a safer investment at the same time that they may pay higher after-tax income.
3. Adding Inflation-Linked Treasury Exposure
In a high-inflation environment, it can make sense to look at Treasury Inflation-Protected Securities, or TIPS. The principal value of these securities rises when inflation goes up. At maturity, investors receive this higher principal amount, adding to their overall return. If there has been no inflation adjustment, investors still get back the original principal amount.
TIPS are usually held in IRAs or other tax-advantaged accounts to help avoid taxes on the inflation adjustments. They can also lose value before maturity if market rates rise. In addition, they can also be a good hedge if inflation stays sticky.
4. Leveraging the Tax Advantages of Real Estate
Wealthy investors aren’t usually the ones out chasing short-term gains from flipping houses. They tend to leverage the tax advantages offered by real estate.
Rental properties, for example, offer a host of tax deductions that can make them extremely tax-efficient.
Another common strategy is the 1031 tax-free exchange. This allows investors to sell one house and use the proceeds to buy another without paying any taxes, according to Fidelity. While this does not eliminate a tax liability, it can repeatedly defer it.
5. Looking at Gold Carefully
Gold doesn’t produce income, and commodities can be volatile. However, investors often use them as hedges against inflation or global crises. The yellow metal spiked to an all-time high of over $5,500 per ounce in January, according to CBS News, but has fallen closer to $4,500 as of September.
If the stock market ever takes a breather, gold may shine again as investors flock to tangible hard assets. Many wealthy investors keep a small allocation of gold and other precious metals as an ongoing insurance policy against so-called “black swan” events.
The Bottom Line
Wealthy investors tend not to panic when borrowing costs spike. Rather than making giant bets, they stick to a game plan that involves some combination of shorter-duration cash reserves, tax-exempt income, inflation-linked securities, tax-deferred real estate strategies and selective hard asset exposure.
The lesson is the same whether you are rich or simply aspire to build wealth: Focus on after-tax returns, take inflation into account with your investments and focus on liquidity to get you through the tough times.
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.