If you lived through the 1970s, one of your greatest sources
of astonishment is probably that interest rates aren't soaring. In that
carbuncle of a decade, you counted yourself fortunate if you got a mortgage at
12%, and cursed your money fund if it paid less than 10%. Nowadays, you worry
that interest rates are going to rise, and soon, and rapidly.
But with interest rates somewhere in the fifth sub-level of
the financial world's parking garage, it's a good bet that sooner or later,
interest rates will rise. The question is how to position your portfolio for
higher interest rates, if, in fact, you should.
You can divide interest rates into two parts. Short-term
interest rates are largely controlled by the Federal Reserve. Its key fed funds
rate is between zero and 0.25%. The Fed has said that it will probably not
raise short-term rates until next year, depending on the outlook for the
economy and inflation.
Long-term interest rates are largely controlled by the bond
market, although the Fed has intervened heavily there as well. Its program of
purchasing long-term bonds and mortgage-backed securities should end by
October. But even as the Fed has tapered its bond-buying program, rates have
fallen. The benchmark 10-year Treasury note yield ended 2013 at 3.03% and
closed Thursday at 2.33%.
Sooner or later,
however, interest rates will rise. You'll notice two immediate effects:
• When the Fed raises interest rates, you'll get better
yields on money market funds and bank CDs.
• You'll get higher yields but lower prices on your bond
funds. Bond prices fall when interest rates rise, and your higher yields won't
be enough to offset your fund's share price.
You can get some idea of how badly your fund will get hit by
a figure called duration, which most funds supply in their literature. A fund
with a duration of 3.5 years will fall 3.5% for every percentage point rise in
Stocks, however, don't necessarily fall when interest rates
rise. Rising rates mean a greater demand for loans, which is an indicator of a
growing economy. Typically, the stock market initially views the start of a Fed
interest rate increase positively — a token that things are headed back to
normal after a recession. It's not until the Fed has hiked rates repeatedly
that the stock market starts to get uneasy — the origin of a once-useful rule
called "Three steps and a stumble." The rule says that after the Fed
has raised its discount rates three times, stocks fall.
How should you prepare for a rise in rates? If you want to
reduce interest-rate risk for your bond funds, consider a CD ladder instead. You
start by dividing the money you'd normally keep in a bond fund into five CDs,
each of which matures one year later than the next. When the one-year CD
matures, roll it into a five-year CD. You'll do this until you're continually
rolling over five-year CDs. You'll continually lock into the highest current CD
rates without losing principal, assuming you don't incur any early-withdrawal
If you're a stock investor, your biggest fear should be a
period of rising inflation and rising interest rates — in which case, both
stocks and bonds will let you down. What can you do?
• Increase the percentage of your portfolio devoted to money
funds. Your yield will rise as the Fed raises rates.
• Look for a high-quality, short-term bond fund.
• Consider adding a fund that invests in Treasury
Inflation-Protected Securities (TIPS. TIPS' principal rises alongside the
consumer price index.
You might also consider adding a 5% position in gold as
insurance against inflation. The easiest way to own gold is through a mutual
fund. If you're a long-term investor, though, your best protection against a
period of high interest rates and high inflation is time.
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