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Prepare Your Bond Portfolio For Higher Interest Rates

Steve Pomeranz

It has been nearly a decade since investors have had to contend with the Federal Reserve raising interest rates. Or, from the savers’ viewpoint, it has been that long since the Fed did them a favor. And a recent article by Tom Petruno of the LA Times highlights how stocks and bonds will likely react to a rate hike when it comes.

See… more than Greece, Russia and other happenings, Wall Street’s No. 1 obsession this year is guessing how soon the central bank will start lifting its benchmark short-term rate from near zero — and how financial markets and the U.S. economy will react when that happens. Predictions of investor reaction range from Armageddon to a nonevent.

Current predictions say the Federal Reserve will raise rates a tiny bit – most likely by 0.25% – in September 2015

Current predictions say the Federal Reserve will raise rates a tiny bit – most likely by 0.25% – in September 2015… but confidence in that prediction changes virtually every day with markets reacting on a micro basis to every tiny bit of economic or rate-related news – no matter how significant or good or bad.

So the first thing I want you to do is ignore the noise.

Then, understand that there is but one direction interest rates can move in… from the rock-bottom level they’re at right now… and that is up … so it’s wise to prepare your portfolio for that inevitable move while not overly worrying about when it might happen.

Trading CDs For Bonds

First off, the cash portion of your portfolio should begin earning a modestly better interest rate – so rates should go up a little on CDs but don’t expect any real income because, as I said, the hike will likely be no more than 0.25%.

Bonds and Bond Mutual Funds

Since we’re talking about interest rates, first let’s look at how bonds might react to a hike and what you should do.

The bond market’s reaction to rising rates is the $42-trillion question – that’s the amount of government, business and bank debt currently outstanding. A significant chunk of that debt is owned by individuals, who have had a ravenous appetite for bonds since the 2007 crisis because with short-term rates near-zero since 2008, the Fed has pushed investors and savers out of low-risk assets, such as bank certificates of deposit, into higher-yielding but riskier assets such as Treasury, corporate and municipal bonds.

But when the central bank starts pushing up short-term rates, longer-term rates will rise as well… and when that happens, existing bonds issued at fixed rates will automatically drop in value because when rates go up, bond prices fall.

In fact, in anticipation of a rate hike, the yield on the benchmark 10-year Treasury note has jumped from 1.64% in February to 2.39% as of last week. One result: Investors who own the popular Vanguard Total Bond Market Index mutual fund, which owns a wide variety of bonds, have seen their share price drop 1.6% year to date.

And, if longer-term yields continue to rise – especially if the U.S. economy continues to get stronger – bond owners’ losses would deepen. So there’s a risk that investors could dump their bond holdings, which would lower bond prices even more and deepen losses.

Business Loans

As the Fed raises rates, borrowing costs – which are pegged to the “prime” lending rate charged to the most creditworthy borrowers – will also go up. The prime rate has been 3.25% since late 2008 and always rises in tandem with the Federal Reserve’s short-term rate. So if the Fed initially raises its rate 0.25 percentage point, the prime will instantly rise to 3.50%, and rates on all loans pegged to the prime will rise by the same amount.

Credit Cards

Plastic debt typically is the most expensive debt, and the cost of carrying a balance on your card will rise with every Federal Reserve rate hike. So your best defense against rising interest costs: pay down your credit card debt.

Basic Moves to Protect Your Bond Portfolio

First, if you own a bond fund, check its “average maturity” on the fund’s website – this will tell you if the fund owns mainly longer-term bonds or shorter-term bonds. Typically, the longer the average maturity, the greater the drop in the fund’s principal value if interest rates rise. A fund with an average duration of two years, for example, would be much less at risk from rising rates than a fund with an average duration of seven years.

The trade-off is that longer-term bonds pay higher interest rates than shorter-term bonds. So you have to give up some yield to protect your principal.

Second, gauge the quality of your bonds. Some fund managers believe that investors desperate for better yield have overly bid up prices on lower-quality bonds – up to dangerous levels, and will flee these “junk” bonds quickly if the Fed starts raising rates… so junk bond prices could be the first to fall. So, perhaps, consider exiting your low-quality bonds and moving into high-quality U.S. home mortgage bonds and commercial mortgages.

Third, if you can’t stand the thought of losing any money in bonds, consider moving part of that investment into safe cash accounts. Many wealth managers now say that their typical client portfolio is 10% to 20% in cash, compared with 5% to 7% two to three years ago – with the idea of waiting to buy higher-yielding bonds later if rates rise.

So those are some thoughts on how you can manage your bond portfolio in anticipation of an increase in interest rates. Next week, I plan to talk about how you can protect your stock portfolio in a rising interest rate environment.