How to Prepare for Rising Interest Rates

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By MARK P. CUSSEN
 Updated Jun 25, 2019
TABLE OF CONTENTS

 Cut Bond Duration

 Look to Stocks
 Use Bond Ladders
 Beware of Inflation Hedges
 Bet on the U.S. Dollar
 Reduce Your Risk
 Refinance Your Home
 The Bottom Line

When interest rates hover near historic lows for extended periods, it becomes
easy to forget that what goes down will eventually come back up. Rates will
generally begin to rise as an economy rebounds. When this happens, both short-
and long-term fixed-income investors who are caught unprepared may miss out
on an easy opportunity to increase their monthly incomes. For this reason, now is
the time to begin preparing for this shift in the interest rate environment.

(Check out How Interest Rates Affect The Stock Market for an introduction to this
issue.)

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How To Prepare For Rising Interest Rates

Cut Bond Duration

Topping the to-do list, investors should reduce long-term bond exposure while
beefing up their positions in short- and medium-term bonds, which are less
sensitive to rate increases than longer-maturity bonds that lock into rising rates
for longer time periods. But flipping to a shorter-term lower-yielding bond model
has a trade-off, as short-term bonds provide less income earning potential than
longer-term bonds.
One solution to this conundrum is to pair short-term bonds with other
instruments, including floating-rate debt such as bank loans, and Treasury
Inflation-Protected Securities (TIPS), whose adjustable interest rate is less
sensitive to rising interest rates than other fixed-rate instruments.

TIPS are adjusted twice a year to reflect changes in the U.S. Consumer Price
Index (CPI), a benchmark for inflation. If price levels rise, the coupon payments
on TIPS react similarly. As for floating rate loans, these instruments invest in
riskier bank loans, whose coupons float at a spread above a reference rate of
interest. Thus, they adjust at periodic intervals as rates change. A few TIPS
exchange-traded funds (ETFs) include:

 The Schwab U.S. TIPS ETF (SCHP)

 SPDR Barclays TIPS (IPE)
 iShares TIPS Bond ETF (TIP)
 PIMCO 1-5 Year U.S. TIPS Index ETF (STPZ)

Similarly, there are also examples of floating-rate debt ETFs that include:

 iShares Floating Rate Note Fund (FLOT)

 SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN)
 Market Vectors Investment Grade Floating Rate ETF (FLTR).

Look to Stocks
Not all strategies that profit from rising rates pertain to fixed-income securities.
Investors looking to cash in when rates rise 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 seen
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.

(For more on inflation, take a look at How Interest Rate Cuts Affect Consumers.)

Use Bond Ladders

Of course, a common strategy 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. The same process works for CD laddering.
The following example illustrates this process:

Larry has $300,000 in a money market earning less than 1% interest.

His broker advises him that interest rates are probably going to start rising
sometime in the next few months. He decides to move $250,000 of his
money market portfolio into five separate $50,000 CDs that mature every 90
days starting in three months.
Every 90 days, Larry reinvests the maturing CD into another CD paying a higher
rate. He may invest each CD into another of the same maturity, or he may
stagger the maturities according to his need for cash flow or liquidity.
(Learn more about the bond ladder in The Basics Of The Bond Ladder.)

Beware of Inflation Hedges

Tangible assets such as 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.

(For more, see Are oil prices and interest rates correlated?)

Bet on the U.S. 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 attract
foreign capital to investment instruments that are denominated in dollars, such
as T-bills, notes and bonds.

Reduce Your Risk

Rising interest rates mean that more conservative instruments will begin paying
higher rates as well. Furthermore, the prices of high-yield offerings (such as junk
bonds) will tend to drop more sharply than those of government or municipal
issues when rates increase. Therefore, the risks of high-yield instruments may
eventually outweigh their superior yields when compared with low-risk
alternatives.

Refinance Your Home

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.

Also, 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.

(Before you run to the bank, check out 9 Things to Know Before You Refinance
Your Mortgage and Got A Good Mortgage Rate? Lock It Up!)

The Bottom Line

History dictates that interest rates will not stay low forever, but the speed at
which rates rise and how far 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 CD or bond
portfolios, strengthening their positions in the dollar and refinancing their homes.
For more information on how to profit from rising interest rates, consult your
financial advisor.

For related reading, take a look at Managing Interest Rate Risk.

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