When interest rates hover around historical lows for a long time, it is easy to forget that what has fallen will eventually rebound. As the economy rebounds, interest rates usually start to rise. When this happens, short-term and long-term fixed-income investors who are caught off guard may miss the easy opportunity to increase their monthly income. Therefore, it is time to start preparing for this shift in the interest rate environment.
How to prepare for rising interest rates
- Compared with longer-term bonds that lock in interest rates for a long period of time, short- and medium-term bonds are less sensitive to rising interest rates. However, short-term bonds provide lower income potential than long-term bonds.
- When interest rates start to rise, investments that hedge against inflation tend to underperform, because rising interest rates will curb inflation
- Just as it is wise to maintain liquidity in a fixed-income portfolio, it is also wise to lock in mortgages at current interest rates before they rise.
Shorten bond maturity
The first task is that investors should reduce their exposure to long-term bonds and strengthen their positions in short- and medium-term bonds. Compared with long-term bonds that lock in interest rates for longer periods, short- and medium-term bonds are less sensitive to interest rate hikes. However, they turn to short-term yields. The lower bond model requires trade-offs, because short-term bonds have lower revenue generation potential than long-term bonds.
One way to solve this problem is to pair short-term bonds with other instruments, including floating-rate bonds, such as bank loans and Treasury Inflation Protected Securities (TIPS), whose adjustable interest rates are less sensitive to rising interest rates than other instruments. Fixed interest rate instruments.
“Historically, inflation risk premiums have tended to be very positive,” said Geert Bekaert, a professor at the Columbia Business School School of Business. “If interest rates rise in the future due to rising inflation (such as rising commodity prices), and inflation risks are suddenly priced again, nominal Treasury bonds will perform very badly, but TIPS will perform well because they are linked to inflation.”
TIPS is adjusted twice a year to reflect changes in the US Consumer Price Index (CPI) (inflation benchmark). If the price level rises, TIPS coupon payments will respond similarly. As for floating-rate loans, these instruments are invested in higher-risk bank loans, and their coupons fluctuate at a spread higher than the reference interest rate. Therefore, they will be adjusted regularly as interest rates change.Some TIPS exchange-traded funds (ETFs) include:
- Schwab U.S. TIPS ETF (SCHP)
- SPDR Barclays Alert (IPE)
- iShares TIPS Bond ETF (TIP)
- PIMCO 1-5 years U.S. TIPS Index ETF (STPZ)
Similarly, there are examples of floating-rate debt ETFs, including:
- iShares Floating Rate Notes Fund (FLOT)
- SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN)
- Market Vectors Investment Grade Floating Rate ETF (FLTR)
Look at stocks
Not all strategies to profit from rising interest rates are related to fixed income securities. Investors who wish to cash out when interest rates rise should consider buying stocks of consumers of major raw materials.
When interest rates rise, raw material prices usually remain stable or fall. Companies that use these materials to produce finished products — or just in their daily operations — will increase their profit margins as costs fall. For this reason, these companies are often seen as a tool to hedge against inflation.
Rising interest rates are also good news for the real estate industry, so companies that profit from housing construction may also be good news. Due to increased consumer spending and lower costs, when interest rates rise, demand from poultry and beef producers may also increase.
Use bond ladder
Of course, a common strategy recommended by financial planners and investment advisors to clients is the bond ladder.
The bond ladder is a series of bonds that mature regularly, for example every 3, 6, 9 or 12 months. As interest rates rise, each of these bonds is reinvested at a new higher interest rate. The same process applies to the CD ladder. The following example illustrates this process:
Larry has $300,000 in the currency market, with an interest rate of less than 1%. His agent told him that interest rates might start to rise sometime in the next few months. He decided to transfer the $250,000 in his money market portfolio to five separate $50,000 CDs, which expire every 90 days starting from three months.
Every 90 days, Larry reinvests the expired CD into another CD that pays a higher interest rate. He can invest each CD in another CD with the same maturity, or he can stagger the maturity according to his needs for cash flow or liquidity.
Beware of an inflation hedge
Tangible assets, such as gold and other precious metals, tend to perform well when interest rates are low and inflation is high. Unfortunately, when interest rates start to rise, investments that hedge against inflation tend to underperform, because rising interest rates suppress inflation.
In a high interest rate environment, the prices of other natural resources (such as oil) may also be hit. This is bad news for those who invest directly in them. Investors should consider reallocating at least a portion of these instruments they hold and invest in the stocks of companies that consume these instruments.
Bet on U.S. dollars
Those who invest in foreign currencies may want to consider increasing their holdings in Old Uncle Sam. When interest rates start to rise, the U.S. dollar usually gains momentum against other currencies, because higher interest rates will attract foreign capital to U.S. dollar-denominated investment instruments, such as Treasury bills, bills, and bonds.
Rising interest rates mean that more conservative instruments will also begin to pay higher interest rates. In addition, when interest rates rise, the prices of high-yield products (such as junk bonds) tend to fall faster than the prices of government or municipal bonds. Therefore, compared with low-risk alternatives, the risks of high-yield instruments may eventually exceed their superior returns.
Refinance your home
Just as it is wise to maintain liquidity in a fixed-income portfolio, it is also wise to lock in mortgages at current interest rates before they rise. If you are eligible to refinance your home, now may be the time to do so.
In addition, keep your credit score, pay off those small debts, and visit your bank or loan officer. Locking in a mortgage at a 5% interest rate and then getting an average yield of 6.5% on your bond ladder is a low-risk way to ensure profits. It is also a good idea to lock in low interest rates on other long-term debts, such as car loans.
History shows that interest rates will not stay low forever, but the speed and magnitude of the rise in interest rates are difficult to predict. Those who do not pay attention to interest rates may miss valuable opportunities to profit in an environment of rising interest rates.
Investors can profit from rising interest rates in a variety of ways, such as buying stocks in companies that consume raw materials, increasing their CD or bond portfolios, strengthening their positions in the U.S. dollar, and refinancing their homes. For more information on how to profit from rising interest rates, please consult your financial advisor.