How To Play Rising Rates

How To Play Rising Rates

The Bond Boom Has Left Many Investors Vulnerable to a Surprise Jump in Interest Rates. Here's How to Protect Yourself—and Profit .Article NewStock Quotes Comments (4) more in Personal Finance
At first blush such a move might seem like portfolio suicide. The main drivers of rising interest rates—economic growth and inflation—are nowhere in sight. In fact, Treasury yields could fall further if the Federal Reserve starts buying bonds again in a widely anticipated maneuver known as "quantitative easing."


Fed Chairman Ben Bernanke has hinted that the central bank will begin another round of 'quantitative easing.'
.But step back from day-to-day market gyrations and a different picture emerges. Bond yields have fallen for most of the past three decades. A $1,000 investment in the U.S. government debt in 1980 would be worth about $12,970 today, according to the Ryan Labs Treasury Composite Index. Treasury prices, which move in the opposite direction of yields, have surged 9.3% this year alone.

Now consider a different era: 1949 through 1979. Over that 30-year span, a $1,000 initial investment in Treasurys would have turned into a far humbler $2,950. That's because yields soared during the period; by 1980 the yield on the 10-year Treasury had reached a record high of nearly 16%.

Given that Treasury yields have since plunged back down to 2.5% or so, how much further can they fall? That's the question some big investors are asking. In recent months bond-fund firms Pacific Investment Management Co. and others have pared back their holdings of Treasurys in favor of stocks (see "Amid a Bond Boom, Some Investors Turn to Stocks").

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John Kuczala

.The latest rallying cry for bond bulls has been quantitative easing; prices have soared amid expectations that the Fed will once again buy bonds to reduce interest rates and boost the economy. Economists and market watchers increasingly are predicting a second round of quantitative easing later this year.

In the short term, that would likely result in lower bond yields. But rates might not stay low for long. The purpose of more quantitative easing would be to reduce the chances of Japan-style deflation over the longer term by boosting inflation. Since the Fed can basically print money, investors would be wise to respect its ability to cause inflation if it desires.

It wouldn't take much of a rise in rates to pose problems for investors. A one-point jump in Treasury yields would translate to a 5% loss for the 10-year Treasury note and a 12% drop for a 30-year Treasury. Many strategists are predicting 10-year Treasury rates above 3% over the next year.

Yet investors are ill-prepared for a period of rising yields, says Rob Arnott, the founding chairman of investment firm Research Affiliates in Newport Beach, Calif. "This will be a common and costly mistake."

There are, however, ways investors can protect their portfolios from rising yields—and even profit from them. The key: focusing on the short term and finding assets with less sensitivity to interest rates and more to economic growth. Here are some ideas.

Cash
Investors who think rates will rise should shorten the maturities of their bonds and move cash into short-term bond funds and certificates of deposit. Yes, they will sacrifice yield—but they will have more cash on hand to invest when rates start to rise.

"It keeps the powder dry," says Tim Tarpening, senior portfolio strategist at Pacific Income Advisers in Santa Monica, Calif.

How to Play Rising Rates

Floating-Rate Debt: Floating-rate loans gained 9.1% from September 1993 through November 1994 as the Federal Reserve raised rates 2.5 percentage points. Advice: Check the credit quality of the fund's portfolio and its use of leverage to ensure you're not adding too many other sources of risk.
Dividend-Paying Stocks: Investors pick up an annual yield of 2.6% by buying the Dow for its dividends, compared with the 2.5% yield of the 10-year Treasury note. Advice: Investors can buy a dividend-weighted index fund to get a yield boost—and additional upside if rates rise.
High-Yield Bonds: The SPDR Barclays High Yield Bond ETF gained 7.2% during the past four months. Advice: Buy high-yield bond funds with short duration and an average credit rating close to BB—or buy one of three highyield ETFs.
Convertible Bonds: Convertible bonds gained 18.1% in the 12 months starting May 2003, as 10-year Treasury yields rose 1.28 percentage points. Advice: Buy a multisector bond fund that has a large portion of its portfolio in convertible bonds.
.The goal is to find funds that have a low "duration," a measure that tracks how much of a bond's return came from coupon payments and how much from return of principal. The higher the duration, the more interest-rate risk. According to investment-research firm Morningstar Inc., the average intermediate-term bond fund has a duration of 4.4 years, while short-term funds average 1.8 years and ultrashort bond funds average 0.6 years.

Investors also might consider high-quality money-market funds, because with rates so low, the market isn't putting much of a premium on riskier assets, says Lance Pan, director of investment research at Newton, Mass.-based Capital Advisors Group. The largest retail money-market funds are the Fidelity Cash Reserves and Vanguard Prime Money Market Fund, according to iMoney.net.

Floating-Rate Debt
Investors worried about rising rates should add floating-rate bonds and loans to their portfolios, says Elizabeth Fell, a fixed-income strategist at Barclays Wealth. Because their rates are adjustable, their yields rise alongside interest rates. From May 2003 through May 2004, for example, 10-year Treasury yields rose 1.28 percentage points, while the Credit Suisse Bank Loans Index rose 9.0%.

One way investors can get exposure to floating-rate securities is through mutual funds, Ms. Fell says. Of the 28 floating-rate funds tracked by Morningstar, two are rated five-stars: Fidelity Advisor Floating Rate High Income, which has its largest position in a Community Health loan that matures in July 2014, and the RidgeWorth Seix Floating Rate High Income Fund, whose largest position is a Ford Motor Co. floating-rate note that matures in December 2013.

Kathryn Young, an analyst at Morningstar, says investors should also check the credit quality of the bonds in the portfolio and the amount of leverage the fund uses by studying the fund's website and prospectus.

High-Yield Bonds and Convertibles
If rates start to rise, it will likely mean that economic data is coming in better than expected. That would be good for high-yield or "junk" bonds, which are more sensitive to economic growth than to interest rates. The Barclays High-Yield Bond Index has zero correlation with medium- to long-term Treasurys, meaning the two don't rise and fall in tandem.

Junk bonds have performed well during periods of rising rates. They gained 10.6% from December 1995 through March 1997, for example, as 10-year rates rose 1.33 percentage points.

Junk bonds aren't a screaming bargain these days. Typical yields have dropped to 7.5%, well below their long-term average of 10.31%, according to data from Deutsche Bank AG. But the yield difference between junk bonds and Treasurys is six percentage points, only slightly below its long-term average of 6.44 percentage points and well above its all-time low of 2.56 percentage points in 2007.

Convertibles, like corporate bonds, also pay a regular coupon. But in exchange for a lower regular payment, investors get the option of turning the bond into a stock at a later date. That makes convertibles much less sensitive to changes in yields.

The Merrill Lynch Convertible-Bond Index, for example, has zero correlation to medium-term Treasurys. During the 12 months beginning in May 2003, convertibles gained 18.1% even as Treasurys lost about 0.5%. From September 1998 through January 2000, they zoomed 40.5% as Treasurys lost nearly 2%.

"Convertibles move with the economy," says Carl Kaufman, portfolio manager of the $1.2 billion Osterweis Strategic Income Fund. Mr. Kaufmann likes a convertible bond from oil-and-gas producer Penn Virginia Corp. that yields 5.75% and matures in November 2012, and another from education supply company School Specialty Inc. that yields about 6.5% until Nov. 30, 2011. As of June 30, the fund had 24% of its assets in convertible bonds.

To gain exposure to these asset classes, Lewis Altfest, CEO and chief investment adviser at Altfest Personal Wealth Management in New York, suggests multisector bond funds, which have the ability to go where they see the most value. The downside: With bond funds, investors don't have the option of holding bonds to maturity. If rates start to rise and investors head for the exits, the fund manager may be forced to sell at a loss.

Mr. Altfest's current favorite is the Loomis Sayles Bond Fund, which has an 8.7% position in convertibles and a quarter of its portfolio in high-yield bonds.

Dividend-Paying Stocks
Another play on rising bond yields is to buy dividend-paying stocks. In 2003, when Treasury yields rose, equity-income stocks outperformed all other income-producing investments, with returns of 31.4%. They gained 7.6% for the 12-months beginning June 2005 when Treasury yields rose 1.22 percentage points.

Much of those gains came from stock price appreciation: as bond yields rise investors tend to rotate into faster-growing stocks.

The bond rally has presented relative bargains in dividend-paying stocks. The Dow Jones Industrials have a dividend yield of about 2.6% now, compared with 2.5% for 10-year Treasurys. And dividend payments, like bond yields, tend to rise with inflation.

What's more, the regular dividend payments act as a cushion if stocks fall. "Dividend stocks should do well when yields rise, but also do well in a low-for-longer environment," says Hannes Hofmann, head of U.S. equities at JP Morgan Private Bank.

The SPDR S&P Dividend Fund and the iShares Dow Jones Select Dividend Fund track indexes that include the highest dividend payers and try to avoid companies whose payments seem unsustainable. The S&P Dividend fund has a yield of 3.59%; the Select Dividend Fund's yield is 3.79%.

Investors who want to do it themselves should focus on companies whose dividends are high, but not so high that they can't continue to grow. Since 1984, stocks in the second quintile of the Russell 1000 as ranked by dividend yield have outperformed the other four quintiles as well as companies that don't pay dividends, according to Savita Subramanian, head of quantitative strategy at Bank of America Merrill Lynch. Stocks in that group include Exxon Mobil Corp., which has a dividend yield of 3.1%, and McDonald's Corp., which pays a 3.3% dividend.

Investors also should look for companies that have pricing power, says Matt Freund, senior vice president of investment portfolio management at USAA. That means investing in large companies, such as Johnson & Johnson, General Dynamics Corp. and Kimberly-Clark Corp., and companies nearest the beginning of the commodity-supply chain—energy and material companies, such ConocoPhillips and Royal Dutch Shell PLC.

Commodities and TIPS
If yields rise too steeply it would likely mean that inflation has spiked. One way investors can play rising inflation is via commodities, which are usually denominated in dollars and tend act as a hedge against inflation, rising in value as prices of other goods and services rise.

The Dow Jones UBS Commodity Total Return Index, which tracks 19 commodities, has a 0.4 correlation with the consumer-price index, meaning they tend to move up as risks of inflation—and rising rates—increase.

Historically, the cleanest way to buy commodities has been via futures. In recent years commodities ETFs have emerged as well. Some, like the SPDR Gold Shares, hold the physical commodity in reserve. Many others, however, buy and sell the futures tied to commodities, which can add another layer of risk.

For investors who prefer mutual funds, Mr. Altfest recommends the Pimco Commodity Real Return Strategy Fund, which holds energy, livestock, grains, industrial and precious metals and other commodities.

It also holds Treasury inflation-protected securities, or TIPS, whose yields rise with the consumer price index.

Other Pimco funds are loading up on TIPS, too. In August, the Pimco Global Multi-Asset Fund bought long-term TIPS, citing their yield compared with the equivalent noninflation-protected Treasury.

But for investors seeking diversification as well as protection from rising rates, the commodity fund may be the way to go. "It's a play on commodity futures but also has inflation-protected bond yields," Mr. Altfest says. "It's a great fund if you think inflation and commodity prices will take off."

—Jane J. Kim contributed to this article.
Write to Ben Levisohn at ben.levisohn@wsj.com