Prepare Your Portfolio for Rising Rates

The economy showed signs of improving in the second quarter of 2014: Sales of autos and durable goods were stronger, retail sales recovered and business inventories grew.

The Federal Reserve has kept interest rates at historically low levels for years as the economy rebounds. Federal Reserve Chairman Janet Yellen has said that she will provide the markets as much aid as possible for as long as it takes, keeping rates low until the economy’s growth has reached its potential.

If the improving economic signals are any indication, that could be soon. Economists expect the Fed will complete its bond buying and begin to evaluate raising the federal funds rate when the U.S. unemployment rate falls below 6 percent, which could happen by mid-2015.

The biggest threat to the individual investor in this environment may very well be traditional bond investments. When I got in the business in 1994, bonds looked eerily similar to the way they do today. They had good long-term track records and seemed like a relatively conservative place to invest. However, when interest rates rise bond prices generally decrease, which can be a terrible loss for anyone who had thought they were investing in something conservative.

It’s important to keep this in mind: If the Fed is raising rates, it believes the economy is getting better, which is good news. This point is often lost on the average investor. Historically, stocks tend to perform well in the months leading up to an initial rate increase. And when interest rates rise, growth stocks often outperform value. In particular, smaller cap companies tend to be more closely tied to the U.S. economy and therefore should have the potential to outperform during periods of economic recovery.

Even small rate increases could have an effect on your investment portfolio, as well as other assets such as a mortgage. Here are some steps you can consider to prepare your portfolio for the possibility of rising interest rates. It’s crucial to work closely with your investment advisor, who can suggest a strategy based on your investment profile, risk tolerance, liquidity needs and financial goals.

• Reallocate. Based on your risk profile, you could reduce some of your bond allocations in favor of equities as part of a short-term strategy. Consider supplementing the resulting reduction in income by looking for dividend growth stocks.
• Reinvest. Bonds with longer durations will be less attractive when interest rates rise, because they will pay less income than newer bonds pegged to the higher rates and do so over a longer period of time. You can create a bond ladder by purchasing an assortment of bonds that mature at different intervals. As each bond matures, proceeds are reinvested in the longest duration security. By reinvesting the proceeds at the current interest rate, you build a portfolio that has an increasing yield as rates rise.
• Refinance. Mortgage rates will likely rise as interest rates do. Now may be the time to refinance, buy a second home or contribute to a child’s home purchase. This could apply for other purchases that may require loans, such as a car, home improvements or even business equipment.

But most importanty, diversify. Shifting your long-term bond allocations may result in reduced income. To offset that, you can look to certain other types of fixed income. It is impossible to know the exact impact of a new economic environment. Investors who keep calm—as well as diversified—will be able to remain confident in their plan.

Brock Kidd can be reached at 615-744-3751, brock.kidd@pnfp.com or 2300 West End Ave., Nashville, TN 37203. Visit his website at http://brockkidd.com/.