What to Do As Interest Rates Rise - Page 3 of 4

What to Do As Interest Rates Rise

brokerage firm in Durham, North Carolina, and she has taken a more balanced approach to diversifying her portfolio. Rising interest rates can signal an opportunity to add bonds to your overall mix of investments.

“[Jones] has a 50-50 allocation between equities and fixed income,” says her adviser, Ed Fulbright, president of the Durham-based financial planning firm Fulbright Financial Consulting P.A. “Last year, her fixed-income holdings were in cash, so she was earning less than 1%.”

Fulbright devised a fixed-income portfolio for Jones that has raised her yield to around 5%, yet minimizes her exposure to rising interest rates. “Some of Harriet’s money is now invested in a pool of secured bank loans,” he says. “If the prime interest rate rises -as most people anticipate -the interest on those loans will rise, too, and her yield will increase.” (See “Follow the Banker,” Moneywise, July 2004.)

“Harriet also has some money invested in a bond ladder -a series of bonds that will mature in one, two, three, four, and five years. When the one-year bonds mature, her money can be reinvested in new five-year bonds, which may be paying higher interest rates. And so on each year,” says Fulbright.

Investors can use Treasury Inflation-Protected Securities (TIPS) and Series I Savings Bonds as ways of preserving capital against inflation. TIPS are marketable Treasury securities with varying maturities that pay a fixed rate of interest every six months applied to an inflation-adjusted principal. Upon maturity, TIPS pay the greater of the inflation-adjusted principal or the original par value. You can purchase TIPS through www.TreasuryDirect.com.

TIPS made the most sense as a long-term buy and hold in June when the interest rate on 10-year TIPS was about 2.8% lower than that of a nominal 10-year Treasury note. That’s
more than the current rate of inflation, which is about 2%. Investors will have to be careful to look for a similar competitive advantage on rates this fall. Also, since the investor pays federal taxes on the principal in any year it grows, TIPS work best in tax-deferred retirement accounts that allow for long-term investing.

I Bonds, like TIPS, have built-in protection against inflation: an interest rate that is adjusted to the Consumer Price Index every six months, in addition to a fixed interest rate that lasts the life of the bond. Coggins recommends I Bonds for a portfolio’s short- to intermediate-term segment.

Overall, Eugene Flood, CEO of the fixed-income investment firm Smith Breeden Associates, says investing in short- to intermediate-term bonds (bonds with maturities under 10 years) is the best way to go. Flood recommends bonds with a two-year maturity and encourages investors to look at “mutual funds that hold those type of securities, especially mortgage-backed securities. Mortgage-backed securities have higher yields when interest rates move higher.”

Pay off debt now. For those grappling with sizeable debt, the threat of rising interest rates is a wake-up call to begin an aggressive repayment schedule. When mortgage rates were at rock bottom in the 1990s , many homeowners took out home equity loans and lines of credit