It's only a matter of time before historically low interest rates begin rising. Although industry experts agree this is likely to accelerate sometime later this year, it’s difficult to predict exactly when rates will rise and just how high they’ll climb. For this reason, savvy bond investors should ready an arsenal of strategies to hedge against rising rates. Preparation is paramount, as strategy development and execution take time to properly implement.
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, 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 top TIPS ETFs include the Schwab U.S. TIPS ETF (NYSE Arca:SCHP), SPDR Barclays TIPS (NYSE Arca:IPE), iShares TIPS Bond ETF (NYSE Arca:TIP) and PIMCO 1-5 Year U.S. TIPS Index ETF (NYSE Arca:STPZ).
Similarly, three big floating-rate debt ETFs are the iShares Floating Rate Note Fund (NYSE Arca:FLOT), SPDR Barclays Capital Investment Grade Floating Rate ETF (NYSE Arca:FLRN) and Market Vectors Investment Grade Floating Rate ETF (NYSE Arca:FLTR).
The smaller yields of short-term bonds have had the ancillary effect of triggering greater U.S. investment interest in European periphery bonds. These higher-income-yielding government bonds offer refuge from emerging-market economic uncertainty. And prospective stimulus programs from the European Central Bank are further ramping up the demand for these securities even more.
Taking More Risk
Investors with the nerve can choose to turn up the dial on risk with their fixed income investments by considering corporate debt, either investment-grade or non-investment grade. Protect against greater credit risk and volatility, though, by diversifying industries and issuers. Aside from traditional bonds, savvy investors should look at dividend-producing stocks, preferred shares, real estate investment trusts and convertible bonds.
Climbing the Ladder
Above all, the tried-and-true “bond ladder” method is the most-often-recommended strategy by advisors and financial planners alike. Bond ladders are successions of bonds -- each reaching its maturity at discrete intervals (three months, six months, 12 months, etc.). As interest rates climb, each bond is redeemed and reinvested in the newer, higher-rate bond. The identical procedure is likewise employed with CD laddering. An investor with $500,000 in a money market account earning 1% interest carves out $400,000 to buy four separate $100,000 CDs that mature every 60 days, beginning in two months. Under this scenario, the investor re-invests the maturing CD into either another CD of identical maturity, or into any one of differing maturities, in accordance with his liquidity/cash flow needs.
While shrewd fixed income investing is the most traditional way of capitalizing on spiking rates, equity investors may also cash in by targeting end consumers of raw materials. Since raw material costs tend to hold steady or decline when rates rise, companies using them, either in their daily operations or as components of their finished goods, often enjoy corresponding growth in profit margins. Beef and poultry producers also stand to gain among escalating interest rates because they’re likely to see increased demand, resulting from higher consumer spending coupled with shrinking costs. And real estate stocks also tend to do well in this climate, making homebuilding and construction companies attractive plays as well, at least until the barrier of pricier mortgages prevails.
Forex investors should think about increasing their exposure to the U.S. dollar. The greenback gains momentum against other currencies when interest rates begin rising and foreign capital is channeled towards dollar-denominated instruments, such as notes, bonds and Treasury bills.
While it makes good fiscal sense to maintain a liquid fixed-income strategy, it’s equally smart for homeowners to refinance mortgages at current rates. Securing a 5% mortgage then harvesting a healthy yield on your bond ladder is a ticket to profits. It’s also prudent to cement low rates on car loans and other long-term debt while you can.
Generally speaking, climbing rates mean conservative instruments start paying higher rates. The price of junk bonds and other high-yield offerings typically fall more precipitously than those of government or municipal issues, hence the risk of high-yield instruments ultimately may outweigh superior yields, compared to their lower-risk alternatives.
The Bottom Line
Knowing when low interest rates will bottom out and begin their ascent is a difficult call. But those who fail to prepare for interest rate moves will likely miss out on significant profit potential and see their cash holdings lose relative value. The best strategy should be a combination of several inflation-hedging strategies.