From 2008 through 2012 investors poured more than $1 trillion in net flows into bond mutual funds, while pulling more than $250 billion from stock funds. But bonds and bond mutual funds are not without risks—including one worth paying particular attention to now: interest rate risk. When interest rates hover near historic lows for extended periods of time, it becomes easy to forget that what goes down will eventually come back up. However, rates will generally begin to rise as an economy rebounds. Therefore, now is the time to begin preparing for this shift in the interest rate environment.
Not all strategies that profit from rising rates pertain to fixed-income securities. Investors looking to cash in when rates increase should consider purchasing stocks of major consumers of raw materials. The price of raw materials often remains stable or declines when rates rise. The companies using these materials to produce a finished good – or simply in their day-to-day operations – will see a corresponding increase in their profit margins as their costs drop. For this reason, these companies are generally viewed as a hedge against inflation.
Rising interest rates are also good news for the real estate sector, so companies that profit from home-building and construction may be good plays as well. Poultry and beef producers may also see an increase in demand when rates rise, due to increased consumer spending and lower costs.
Some things to consider when interest rates are on the rise:
1. Consider Getting in the Equity Game
Many investors agree that rising interest rates do not necessarily imply bad news for the equity market. Interest rates are rising because uncertainty is lifting and the economy is getting better. If yields are rising, it means growth is improving and companies have pricing power. It’s not the end of the world when rates go up, as long as it’s going up for the right reason, and stocks generally do OK.
2. Shorten Duration
Let’s say you have a non-retirement goal with a shorter investing timeline—like paying a college tuition bill for which you need a lump sum in less than four years—and cannot afford much risk to the value of the principal. Or maybe you are already living on a fixed income, investing in bonds to create income. Or maybe you can’t stomach the thought of adding risk to you portfolio.
Choosing high-quality bonds or bond funds with shorter duration’s can help to mitigate the effect of rising rates. These bonds typically pay less than longer-term bonds and riskier bonds—so their low yields may not be right for investors with longer time frames. But these bonds do mature more quickly, allowing you or the fund manager to put that cash into higher-paying bonds sooner, helping to manage one of the challenges of rising rates.
3. Get Your Ladder Ready
One of the most common strategies that financial planners and investment advisors recommend to clients is the bond ladder. A bond ladder is a series of bonds that mature at regular intervals, such as every three, six, nine or 12 months. As rates rise, each of these bonds is then reinvested at the new, higher rate.
4. Beware of Inflation Hedges
Tangible assets like gold and other precious metals tend to do well when rates are low and inflation is high. Unfortunately, investments that hedge against inflation tend to perform poorly when interest rates begin to rise simply because rising rates curb inflation. The prices of other natural resources such as oil may also take a hit in a high-interest environment. This is bad news for those who invest directly in them. Investors should consider re-allocating at least a portion of their holdings in these instruments and investing in stocks of companies that consume them instead.
5. Don’t Forget the Dollar
Those who invest in foreign currencies may want to consider beefing up their holdings in good old Uncle Sam. When interest rates start to rise, the dollar usually gains momentum against other currencies because higher rates attracts foreign capital to investment instruments that are denominated in dollars, such as T-bills, notes and bonds.
6. Refinance Now
Just as it is wise to keep your fixed-income portfolio liquid, it is also prudent to lock in your mortgage at current rates before they rise. If you are eligible to refinance your house, this is probably the time to do so. Get your credit score in shape, pay off those small debts and visit your bank or loan officer. Locking in a mortgage at 5% and then reaping an average yield of 6.5% on your bond ladder is a low-risk path to sure profits. Locking in low rates on other long-term debt such as your car loan is also a good idea.
7. Accept More Risk For Higher Interest Potential
If you can tolerate greater credit risk and volatility, consider investment-grade or non-investment-grade corporate bonds. Despite periods of dramatic price changes, over the long term their relatively high income has contributed the most to their historic overall return. (Remember, past performance is no guarantee of future results.) Given the inherent credit risk associated with these types of bonds, it’s important to diversify across many different issuers from different industries.
Beyond traditional bonds, there are other income options. Consider real estate investment trusts, or stock/bond hybrids like convertible bonds, preferred shares, and dividend-producing stocks. Each can have unique risks, and aren’t right for everyone, but they may be worth investigating.
8. Look For Products That Adjust to Changing Rates
If the thought of navigating a changing market seems complicated or daunting, you don’t have to go it alone. A number of investing products aim to help mitigate the impact of rising rates, including:
- Real return funds: Real return funds try to provide inflation protection by investing in debt securities such as U.S. TIPS and floating-rate loans, as well as commodities and real estate–related investments. The types of bond investments often found in these funds may be less sensitive to rate changes than typical bonds.
- TIPS or TIPS funds: Treasury inflation-protected securities (TIPS) are adjusted semiannually to reflect changes in the U.S. government’s consumer price index (CPI), 3 a well-known measure of inflation. TIPS are tied to CPI in the hope that as the broad price levels in the U.S. economy rise, TIPS coupon payments will also go up. That potential flexibility could help mitigate the price loss of a rate increase.
- Floating rate loans: Floating rate loan funds invest in non-investment-grade bank loans whose coupons “float” at a spread above a reference rate of interest, and thus automatically adjust at periodic intervals as interest rates change.
Of course, there is no free lunch in investing, and each of these comes with trade-offs.
The Bottom Line
History dictates that interest rates will not stay low forever, but the speed at which rates rise and how far up they climb is difficult to predict. Those who pay no attention to interest rates can miss out on valuable opportunities to profit in a rising rate environment. There are several ways that investors can cash in on rising rates, such as buying stocks of companies that consume raw materials, laddering their bond portfolios, strengthening their positions in the dollar and refinancing their homes. For more information on how to profit from rising interest rates, please consult with our investment team at Ragain Financial at 239-948-0314.