Rising rates are inevitable, but needn’t torpedo either bond or equity investors.
Interest rates are not lobsters: They won’t sit at the bottom forever. Either growth or inflation will pick up and the Federal Reserve will be forced to reverse course and raise the discount rate.
So, how do you ready your portfolios for the inevitable?
If you’re anticipating a prolonged increase in interest rates, avoid longer dated debt in favor of shorter-term securities, especially if fixed income is a big part of your portfolio. That’s because as the duration of your fixed-income portfolio increases, each hike in interest rates will affect long-dated bond prices much more than prices of short-term paper.
Also, consider using the traditional bond ladder strategy whereby several shorter-term securities replace a longer-term security. For example, instead of locking in a low interest rate with a 5-year bond, spread exposure over five years.
That means that each year a rung of the ladder matures, at which point you can build a new rung with a note that will expire in five years' time.
The benefits are twofold: For one, instead of being constantly stuck earning less than the prevailing interest rate, the regular maturities allow cash to be reinvested at higher rates. In addition, the strategy increases the probability of realizing price appreciation on a retracement as interest rates advance.
If you prefer to avoid the hassle of a bond ladder strategy, consider one of the following floating rate ETFs which would help prevent you from getting locked into low-yielding securities: the SPDR Barclays Capital Investment Grade Floating Rate ETF (NYSEArca: FLRN), the iShares Floating Rate Note Index Fund (NYSEArca: FLOT) and the Market Vectors Investment Grade Floating Rate ETF (NYSEArca: FLTR).
A couple weeks back I wrote a blog about PIMCO’s 25+ Year Zero Coupon U.S. Treasury ETF (NYSEArca: ZROZ), which was up 75 percent over a one-year period and was the best-performing ETF of 2011.
ZROZ was the best performing ETF because it maxes-out on duration, which is exactly what you want to hold when interest rates are falling.
But if you’re confident that interest rates are headed upward, consider owning PowerShares DB 3X Short 25+ Year Treasury Bond ETN (NYSEArca: SBND), the ETN that attempts to do the opposite of ZROZ; namely, to sell duration short as much as possible. However, leveraged products contain their own set of pitfalls so be sure you know what you’re getting into, as my colleagues Devin Riley and Ana Kostioukova have written about.