Once interest rates reach near zero levels (which is where they were through the early part of 2013) there’s nowhere for them to go but up. That’s exactly what they started to do last spring, particularly once the Federal Reserve began sending up smoke signals about their bond buying tapering. The good news on interest rates, it seems, may be behind us.
This means it may be time to begin preparing your investments for rising interest rates.
There’s no scientific way to do this — much depends on how quickly interest rates rise, and how high they ultimately go. But there are strategies you can use to help you weather an environment of gradual but modest increases in interest rates.
Invest in Companies More Resistant to Rising Interest Rates
It’s probably not possible to say any single industry sector is interest rate resistant. All will be affected to one degree or another, but there are sectors that tend to do better than others in rising interest rate environments.
Healthcare is such a sector that tends to withstand negative developments better than other sectors. It is a solid growth field and tends to grow no matter what is happening in the general economy, simply because people always need healthcare.
Food related stocks, including grocery store chains, can also be somewhat resistant. Since people always need to buy food, food related businesses tend to be less affected by rising interest rates than other sectors.
Invest in Companies with a History of Increasing Their Dividends
Dividend paying stocks tend to react somewhat like bonds in a rising rate environment. This is to say the stock price of dividend paying companies will generally fall with rising rates, since they compete directly with interest bearing investments. This is particularly true of companies that maintain fairly constant dividend payouts.
The exception is dividend paying stocks in companies with a history of steadily increasing their dividend payouts. This isn’t to say such companies are completely resistant to rising interest rates, but the effect of those increases tends to be minimized.
Though rising rates may negatively impact the stocks on a short-term basis, the eventual increase in the dividend payout will minimize the impact.
Also, since companies that steadily increase their dividends tend to be solid growth companies, the stocks can be superior long-term plays, even in a rising rate market. Eventually, their growth can outstrip rising rates.
Invest in Stocks of Companies with Low Debt Levels
Rising rates can have a negative effect on the general economy, which can reduce sales and profits to most companies. But if those companies also carry relatively large levels of debt, they’ll be dealing with an additional problem — a higher debt service. This will also cut into profits, causing additional declines in stock price.
But companies with relatively low levels of debt (compared to their primary competitors) are less impacted by rising debt service. They may even find room for growth in their market as a result of weakened competition from their over-indebted industry rivals.
Companies with lower debt levels than the industry standard could benefit from rising interest rates by default, and are worth considering if you think interest rates will rise even more in the future.
Reduce Exposure to Long-Term Debt Securities
Bonds have an inverse relationship with interest rates. When interest rates rise, bond prices fall; when interest rates fall, bond prices rise.
At the top of this list are long-term bonds, particularly those with remaining maturities of greater than 20 years. The longer the term of the bond, the greater the risk of a price decline. This makes a strong case for lowering your exposure to long-term debt securities of any kind.
This includes not only individual bonds, but also any bond funds you hold which invest primarily in longer-term securities. And while the effect on shorter-term interest-bearing securities is less than what it is on long bonds, it’s still negative.
At a minimum, your money may be tied up for the next five years in an intermediate-term security paying 2%, while you could be missing out on a 3% return on a recently issued security of similar duration.
Park Extra Cash in Money Market Funds
If you are completely spooked by the prospect of rising interest rates, you can always default to money market funds. And this isn’t a bad choice if you have spare cash or investments you think might take a hit, and you’re looking for a place to park the money to ride out the storm.
While it’s true money market funds don’t pay much right now, they do offer two valuable benefits in a rising interest rate market:
- The interest rate return on them will rise as general rates rise, and
- They are completely liquid, and can be shifted anywhere you need them, on short notice.
If you are at all confused as to what to do with your money in a rising interest rate environment, you can park your money safely in money market funds — at least until you figure out what your next move will be.
What do you think is the best way to handle your investment portfolio in a rising interest rate environment?