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. 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. This article explores some of the basic, time-tested strategies that any investor or trader can use to profit in a rising interest rate environment. (Check out How Interest Rates Affect The Stock Market for an introduction to this issue.)
Trimming Bond Duration in Rising Interest Rate Environments
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 TIPS exchange-traded funds (ETFs) include the Schwab U.S. TIPS ETF (NYSE Arca: SCHP), the SPDR Barclays TIPS (NYSE Arca: IPE), the iShares TIPS Bond ETF (NYSE Arca: TIP) and the PIMCO 1-5 Year U.S. TIPS Index ETF (NYSE Arca: STPZ).
Similarly, three examples of floating-rate debt ETFs are the iShares Floating Rate Note Fund (NYSE Arca: FLOT), the SPDR Barclays Capital Investment Grade Floating Rate ETF (NYSE Arca: FLRN) and the Market Vectors Investment Grade Floating Rate ETF (NYSE Arca: FLTR).
How To Prepare For Rising Interest Rates
Prepare for Rising Interest Rates by Looking 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.)
Using Bond Ladders to Prepare for Rising Interest Rates
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 in Rising Interest Rate Environments
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?)
Trading Currency when Interest Rates Rise
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.
Reduce Your Risk in a Rising Interest Rate Landscape
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 Before Interest Rates Rise
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 6 Questions To Ask Before You Refinance 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 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 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.