How to prepare for rising interest rates

A fundamental decision for any investor is making the proper asset allocation: How much to place in stock, bonds and cash to meet your investment objective?

Bonds are generally used to fill the role of income in a diversified portfolio. With interest rates at historic lows it is important to recognize the risks presented by the potential for higher interest rates. More importantly, the diversifier role that bonds play in a portfolio should not be ignored.

Consensus is building within the Federal Open Market Committee citing "fatigue about keeping rates near zero" for more than six years. It is just a matter of time before the inevitable happens and rates will start to slowly rise.

Bond prices and interest rate have an inverse relationship. As interest rates rise, bond prices fall. Longer maturity bonds are more vulnerable to rising interest rates as they are locked into rates for a longer period of time.

Investors should not abandon bonds for fear of higher interest rates; however, they may need to tune-up their bond portfolio to adjust for the time when interest rates rise. There are various strategies investors can use to offset the risk of higher interest rates, but in order to offset the possibility of taking more risk than you can assume, the best bet is to use a combination of strategies.

The simplest strategy is to shorten the duration of your bonds. Shorter maturity bonds have a shorter duration than longer term bonds, given that it takes less time to receive all payments of the shorter bond, including interest and principal. Bonds with a shorter maturity reduce interest rate risk while allowing participating in higher yields. As bonds mature they can be reinvested at a higher rate in a rising interest rate environment. Long-term bonds are affected the most in a rising rate environment.

Floating rate, fixed income bonds that have variable interest rates, resetting on a periodic basis using a benchmark, such as LIBOR, and a certain spread over that benchmark can dampen volatility in a rising rate environment. When interest rates rise, the interest rate on floating rate bonds will rise as well and this minimizes the effect of higher interest rates and provides principal stability over the market movement.

High coupon bonds have a shorter duration than lower-coupon bonds because a higher-coupon bond repays at a faster rate. The greater cash flows can be used to invest at a higher rate, which improves the overall yield of a bond portfolio.

In a rising interest rate environment an investor can afford to take some additional credit risk as opposed to interest rate risk. Lower grade corporate and municipal bonds will benefit from an improving economy and continued low default rates. Corporate and municipal bonds normally pay a higher interest rate than similar maturities of government bonds.

Real Estate Investment Trusts, commonly called REITs, also have performed well as an alternative to low fixed income yields and generally respond favorably during a rising rate environment.

Each of the above strategies provides an investment approach that assists investors in dealing with the impact of rising interest rates. We cannot fight the future, we can only anticipate the direction of interest rates and insulate bond portfolios from extreme volatility.


Sharon L. Thornton is senior director of investments for Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.

Published: Fri, Mar 20, 2015