4 sensible approaches to rising interest rates

July 11, 2013

| MoneyRates.com Senior Financial Analyst, CFA

Interest rates are on the rise and causing some serious stock market disruptions in the process. You can sit back and fret about the turmoil -- or you can look for opportunities to take advantage of it.

The key is anticipation. While there are no easy answers to making money in a troubled market, you can think ahead to where you want your portfolio to be when the dust settles and a more normal investment environment resumes.

The challenges of rising interest rates

Treasury bond yields have risen sharply since the end of April, and by the end of June had reached their highest level of the year. In terms of the three primary asset classes of stocks, bonds and cash, this has made for a very challenging environment:

  • Rising yields mean falling bond prices. If the bond market perceives interest rates as heading higher, it will trade bonds at lower prices so that the interest as a percentage of the price adjusts to the anticipated rate. So, rising interest rates directly drive bond prices lower.
  • Rising interest rates disrupt stocks. Higher interest rates are bad for stocks because they can act as a drag on economic growth, and because they create a higher valuation hurdle for stocks. The stock market has seen some very bumpy days over the past month as investors have tried to come to grips with what higher interest rates will mean for stock prices.
  • Savings account interest rates are not yet attractive. Interest rates may be headed higher, but they are starting from a very low level. To make matters worst, CD, savings and money market rates will probably be among the last things to react to higher rates, as banks drag their feet to protect their profit margins.

Responding to rising interest rates

Given those challenges, what kinds of investment moves can you make in a rising-interest-rate environment? Here are four things to consider:

  1. Rebalance your asset mix. Low interest rates forced investors to take more risk in things like stocks, since cash and bonds provided an inadequate return. But once interest rates have moved higher, bonds in particular should be more productive, and could deserve a larger portion of your overall portfolio.
  2. Upgrade your stocks. Sudden downturns that hit stocks across the board can be a rare opportunity to buy top-quality companies at reasonable prices. If there are stocks you've always wanted to own but didn't like the price, make a list now, because the months ahead might just see some of them hit your target price.
  3. Lengthen maturities. Whether it's bonds or CDs, longer-term instruments typically carry higher rates. You don't want to be long while rates are first rising, but as they move higher, gradually start to lengthen the maturities you own.
  4. Shop for savings accounts. Banks are going to react to the rising-interest-rate environment at different times and to different degrees, so don't expect bank rates to move higher in unison. Shop for bank rates to make sure you are with a bank that is on the leading edge of the trend.

Again, none of these moves will shield you from the disruptive effects of rising interest rates. However, they will position you to do better once rates stabilize.

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