5 ways to prepare for higher interest rates

Commentary: Even long-term investors should take note

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By Jeff Reeves

The Federal Reserve just had its annual economic retreat in Jackson Hole, but Chairman Ben Bernanke was nowhere to be found.

Though one man at one meeting doesn’t make or break U.S. monetary policy, Bernanke’s no-show is representative of the general lack of clarity investors have been grappling with lately.

Will there be “tapering” in September? Does tighter monetary policy mean higher interest rates? Who will take the reins of the Fed since it seems clear Bernanke won’t stay on past the end of his term in January?

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While many questions remain unanswered, one thing is painfully clear: The current course of rock-bottom interest rates can’t last forever. So it’s not so much a question of “if” tighter central bank policy will hit, but when.

That gives investors an opportunity to be proactive about their portfolio right now, in anticipation of higher interest rates.

Unfortunately, many investors have no idea what to do. Edward Jones recently asked people what they think about rising interest rates, and 63% think rising rates matter but don’t know what to do about it in their 401(k) or IRA. Even worse, 24% of Americans said they “do not understand this at all.”

It’s impossible to guarantee what moves will be best as rates rise, but if you’re in the dark about what to do with your portfolio here are some tips on how to prepare:

Don’t worry about individual bonds if you’re holding to maturity

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The biggest thing people hear is that when rates rise, the price of bonds go down. That’s true.. but if you are an income-focused investor who holds bonds to maturity it is not a problem. After all, if you never sell the bond, it doesn’t much matter what market pricing is; If you’re content with your coupon payments then simply keep collecting them.

Avoid long-term bond funds

The fact that bond principal declines as rates rise is a big problem for bond funds, however. The vast majority of bond funds do not hold their investments to maturity and thus face losses in principal as a result. Consider that from May to early July, when rates on the 10-year T-Note rose about 1%, the iShares 20+ Year Treasury Bond ETF /quotes/zigman/1480195/quotes/nls/tlt TLT -1.93% lost about 15%. That’s because 95% of the holdings are more than 25 years in duration, and the longer the duration the more susceptible bonds are to interest rate increases.

Consider short-term bond funds

/quotes/zigman/1480195/quotes/nls/tlt TLT 103.95, -2.04, -1.93% /quotes/zigman/1480177/quotes/nls/shy SHY 84.23, -0.07, -0.08%

10%

-10%

-20%

If you don’t like the idea of buying individual bonds but don’t want to get burned by raising rates, short-term bond funds are an alternative. There is still a risk to a loss in principal, yes, but much less so. As a working example, compare the deep declines in TLT to a less than 1% decline in its sister fund, the iShares 1-3 Year Treasury Bond ETF /quotes/zigman/1480177/quotes/nls/shy SHY -0.08% in that same May-to-July period that saw a significant uptick in interest rates. Remember that the yields in shorter-term bonds are much lower, but that’s the tradeoff you’ll have to consider if you want to avoid the risk of losing principal when rates rise.

Don’t forget bond-like stocks

If you’re looking for income, you may be frustrated by this struggle between settling for either risk to bond principal or settling for meager coupon payments. As such, bond-like investments including utility stocks, blue chip telecoms, REITs or other stable dividend payers may be a decent supplement to your income portfolio.

There is obviously risk here of course, and the loss to stocks could be much more significant than the loss to bond funds should things sour. And furthermore, since so many income-sensitive investors are shopping for dividends there are awfully high valuations for many of these players. But if you do your homework, you can find some good dividend stocks or dividend-focused stock funds that are a fair value and relatively stable right now.

Be wary of junk bonds

One way to lose out on bonds in any interest rate environment is to load up on junk bonds that default before they can pay you in full. Keep in mind that in 2009, the junk bond default rate peaked at 14%. While we are still a far cry from those levels, Moody’s recently estimated that junk bond rates will move up substantially from 2.9% in the second quarter to 3.2% by November — a sign that junk may be getting riskier.

Remember, the proper portfolio is a good mix of bonds and stocks and is never set in stone. Even if you settle for bond investments that yield less than you’re comfortable with, you can always rotate back into higher-yield bond funds in a year or two when the dust settles.

Just because you’re a long-term investor doesn’t mean you should ignore one-time events like an interest rate hike.

And just because you make a decision to pivot your investing goals for the next several months doesn’t mean you’re stuck settling for low yield or the risk of principal losses for the rest of your investing life.

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