As the world's economy has finally begun to grow again, many nation's facing the specter of inflation have started raising interest rates again. Both the European Central Bank and China have begun to tighten credit and a variety of other emerging-market nations have also done so. The real million dollar question from investors is when the U.S. government will begin tightening. There now has been six consecutive quarters of positive GDP growth and unemployment has fallen from its peaks. This positive trend means that we are getting ever-closer to the Fed tinkering with short-term interest rates and stopping its Quantitative Easing programs. For those looking for retirement income, this could have serious implications. (For more on interest rates, read Understanding Interest Rates, Inflation And The Bond Market.)
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The Feds impending actions can caused some unpleasant side effects for fixed income seekers. Bond prices are inversely correlated with the direction of interest rates. As the Fed raises rates, a portfolio of fixed-income securities will likely lose value. Bonds with longer maturities suffer more. The longer the maturity of the bond, the bigger the swing in prices. However, with cash, CDs and short-term bond funds like the iShares Barclays 1-3 Year Treasury Bond (NYSE: SHY) paying next to nothing, investors looking to fund their liabilities today are facing a quandary.
Luckily for investors there are some ways to help insulate a portfolio from rising interest rates. Investor's first can look for bonds that have above-average yields and below-average durations. Duration is a way to measure debt issues' price sensitivity to interest-rate movements. By using the duration metric, investors are able to compare bonds across a variety of maturities and coupons. In addition, bonds with higher yields are generally less affected by movements in short-term interest rates. (To take advantage of interest rates, read 5 Things To Do Before Interest Rates Go Up.)
Adding the Protection
Beyond short-dated Treasury bonds, there are a number of options that help mitigate interest rate risk, but still offer more attractive yield profiles. The exchange-traded fund boom has made it easy to add these asset classes to a portfolio. Here are a few picks.
Senior-rate bank loans adjust rates every 30 to 90 days, making them quite attractive in rising rate environments. But because senior loans are often issued to companies with credit ratings below investment grade, they offer higher starting yields than treasuries. Second, these debt instruments usually are secured by a company's physical assets, such as a pipeline, warehouses or equipment. Thus, floating rate loans are a preferred funding method for telecoms, utilities and smaller energy companies. The new PowerShares Senior Loan Portfolio (NASDAQ: BKLN) allows investors to bet on a basket of these securities and yields about 5%. Similarly, investors can use one of the many closed-end funds in the sector like the First Trust Senior Floating Rate (NYSE: FCT) or ING Prime Rate Trust (NYSE: PPR).
With the federal government providing guaranteed payments of principal and interest, mortgage-backed bonds are looking interesting as well. Featuring higher quality bonds issued by Ginnie Mae, the iShares Barclays MBS Bond (NYSE:MBB) has a duration of just 3.6 years and yields over 3%. As mortgages rebound from historic lows, now may be the time for opportunistic investors to enter the sector.
Another way investors can protect against higher interest rates is through bonds issued in other currencies. As the dollar continues its decline, getting paid in variety of other stronger currencies will help lessen interest rate risk. The Market Vectors EM Local Currency Bond ETF (NYSE: EMLC) and the WisdomTree Asia Local Debt ETF (NYSE: ALD) track a variety of non-dollar denominated bonds.
Finally, one of the best ways for investors to protect themselves against rising rates may not be in bonds at all. Dividend stocks a history of raising payouts are especially warranted. Unlike a bond which pays a fixed rate, with stocks you could potentially get a higher dividend year after year. The Vanguard Dividend Appreciation ETF's (NYSE: VIG) index tracks a portfolio of consistent dividend growers and makes an ideal choice for playing rising rates. (For more, check out Dividend Stocks Are The New Bonds.)
With the global economy really beginning to get moving, many central banks have already begun the process of raising interest rates. As the United States moves further into recovery, it's only a matter of time before the Fed also begins such actions. For investors in the bond market, this could prove problematic. The previous picks are a great way to stem some of the interest rate risk, while receiving great current yields as well. (Check out, How to Prepare For Rising Interest Rates.)
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