For the past several years, interest rates have hovered at historic lows. But the current rate of inflation and rising energy prices suggest that rising interest rates are coming. So, what does that mean for your stock portfolio? It means that you may need to make some changes in order to take full advantage of a rising interest rate environment. Here we will examine how to invest when interest rates rise.
Watch out for falling bond prices
Some sectors of stocks will benefit from rising rates while others will not
Diversification is still important
Options and currency traders can benefit
Rates will most likely start to rise at some point in the not-too-distant future. But it is still likely that rates will remain relatively low for years to come. This is due to a variety of factors, such as the economic growth in China and India and their purchases of U.S. debt in large quantities. Other factors include contained inflation and the coordination of central banks. Then there is the general view that U.S. dollar denominated assets are the safest assets in the world to buy. Finally, we have become increasingly adept at managing inflation risk over the past 40 years or so.
Nevertheless, interest rates are almost guaranteed to rise at least somewhat in the near future. Inflation is turning into a runaway train with no engineer to stop it. Furthermore, both stocks and real estate currently stand at all-time highs. This is another strong indicator of looming inflation.
There are several things that you can do to boost your investment portfolio when interest rates start to rise. Here is a list of some of the most common strategies:
Buy bonds with short maturities or floating coupon rates – When rates start rising, you will probably want to eschew bonds with longer maturities. This is because you will be locking yourself in at a lower rate. Short-term bonds such as T-Bills and 1-year certificates of deposit may be a better option because then you can reinvest the money at a higher rate when they mature. Treasury Inflation-Protected Securities (TIPS) may be another good alternative.
They adjust for inflation twice each year. If your risk tolerance is a bit higher, you might want to consider investing in a mutual fund that invests in senior secured corporate loans. Their overall rate of interest will increase as rates rise, and they typically pay higher rates than guaranteed instruments. This is because they are slightly riskier in nature.
Buy futures or options on futures contracts for the U.S. Dollar – When interest rates start to rise, this makes U.S. debt more attractive to investors. This in turn makes the dollar more attractive relative to other currencies. You can also invest directly in the dollar if you invest in currencies.
Sell covered call and buy put options – Interest rates and the stock market tend to move inversely to each other, so when rates start to rise, the markets often take a tumble. Writing covered calls on your stocks can generate additional passive investment income for your portfolio and selling puts on stocks or stock indices can also yield quick profits in some cases.
Just be careful to buy or sell your options at a safe price so that you do not get called out of the stock or take a large loss from your puts. You may also want to consider doing some spreads or straddles with options to take advantage of market volatility, as stock prices tend to become more turbulent when rates rise. If you are not a veteran trader yourself, consider hiring a broker to do this for you. The expense may be worth it in many cases.
Diversify your portfolio – Spread your holdings around to differing classes of stocks (i.e., large-cap, mid-cap, and small-cap) and buy a portfolio of government and corporate bonds (including junk bonds for those with a higher risk appetite).
This is basic risk management. Your portfolio should be able to weather a rising rate environment over time. You should also probably have some foreign portfolio exposure with both equities and fixed-income holdings of various types.
Lock in your debts – If you have an adjustable-rate mortgage or home equity line of credit, then this is a good time to lock in your rate for the long term. You could take out a home equity loan and use the proceeds to pay off your line of credit so that you will not have to worry about rising rates.
You could also refinance your primary mortgage with a fixed-rate loan for the same reason. Then you can make a guaranteed profit if you are able to lock in a fixed rate of 3.75% on your mortgage and then invest in bonds paying 5 or 6 percent.
Harvest your tax losses – Say that one or more of your stock holdings starts to decline in value. If it drops below your original purchase price, it could be a good idea to sell that holding and then buy it back later so that you can realize a capital loss. This can reduce your taxable income for the year. This will increase your refund or reduce the amount you owe when you file.
These are just some of the strategies that you can use to prepare your portfolio for rising interest rates. Of course, proper diversification, such as bond investing, can always cushion the impact of rising rates. But there may still be some specific actions that you can take to profit or protect your money. Just do not wait too long before using them so that you can get the most bang for your money.