How To Stay Cool As Rates Heat Up

Interest rates have shot up, bonds have plummeted, and stocks have suffered as well. Where do investors go from here?

If rising rates have you concerned mainly with your own investment portfolio, the recent volleys of economic news make it difficult to sort out what to do. "The problem is, individuals are being inundated with information that might be useful to a bond trader, but they are trying to make long-term decisions," says Robert Goodman, Putnam Investments' senior economic adviser.

Those who can stomach the volatility may want to wait "until the dust settles" to shift around their investments, says Grace Keeney Fey, executive vice-president at Frontier Capital Management in Boston. But if the specter of rising rates has you spooked, there are several ways you can cut back on the risk in your portfolio.

Most of those moves don't have to be radical. Fixed-income investors need not sell off their bond holdings, even though bonds have plummeted about 12% since long-term rates hit their low in mid-October. The yield on the benchmark 30-year Treasury increased about half a point since the Federal Reserve boosted short-term interest rates a quarter point on Feb. 4. But not every bond is as sensitive to the Fed's action as a 30-year Treasury.

STACCATO STRATEGY. If you believe rates are going up, you should shorten the maturities in your bond portfolio. According to figures from Liberty Financial, if rates rise 1% over the next year, the market value of the 30-year Treasury would fall 11.9%, the 10-year Treasury would decline 6.1%, and the 5-year Treasury would fall 2.4%. After earning about 5% of income on a five-year bond, your total return if you sold the bond would be 2.8% for the year. Under the same conditions, your total return on a 30-year bond would be negative 8.1%. An average maturity of 7 to 10 years is pretty safe in these uncertain times.

A sensible strategy is to slowly start laddering maturities. That means buying bonds with staggered maturities so each year you have cash to reinvest. The advantage of owning securities directly is that your principal is guaranteed at maturity--though if you hold onto a bond that declined in market value because of rising rates, you will miss the opportunity to reinvest at higher yields.

For mutual-fund investors, "this is a great year to dollar-cost average," says Minneapolis financial planner Ross Levin, president of the International Association for Financial Planning. With this technique, you invest a fixed amount of money at regular intervals so that you automatically buy more when prices are low and less when prices are high. In a market such as this one, warns Richard Hoey, chief economist and portfolio manager at Dreyfus, "investors have to be very wary of being whipsawed."

You should also start moving more of your portfolio into cash. But if the paltry yields of money-market funds or short-term certificates of deposit, now both around 3%, don't provide the income you want, consider the next step on the risk spectrum: "ultrashort" bond funds. These funds have average maturities of less than a year, compared with under three months for money-market funds and up to five years for short-term bond funds. The Strong Advantage Fund, for example, has an average duration of under a year and dropped only 2 in share price in the month since the Fed hiked rates, says portfolio manager Jeff Koch.

Rather than moving to bonds with shorter maturities and lower yields, you can also try to protect yourself from interest-rate movements by choosing alternatives to investment-grade corporates and Treasuries. "For the investor who is nervous and frightened about interest rates but still wants to be in fixed-income, we recommend Ginnie Mae and intermediate municipal funds," says Porter Pierpont Morgan, the investment strategist for Liberty Financial.

HOMEWORK. Municipal-bond prices are expected to hold up because there will be less supply (as a result of fewer refinancings) and more demand as individuals confront higher income-tax rates this year, says Fey. But mutual-fund investors should choose wisely, since not all funds will be insulated from rising rates, depending on their holdings, says Amy Arnott, an analyst with Morningstar Mutual Funds. Two muni funds she recommends are Vanguard Municipal Short-Term and Fidelity Spartan Short Intermediate Municipal. In general, to judge how a fund will do, look at its historical returns during periods of rising rates, such as 1987 and 1990, or the first quarters of 1993 and 1992, she suggests.

Mutual funds that invest in mortgage-backed securities are also somewhat insulated from interest-rate risks. Shareholders of these funds suffered when rates declined and homeowners refinanced their mortgages. With stable interest rates, they should deliver yields higher than Treasuries, without the level of prepayment risk. But, as with muni funds, Arnott warns, there is a wide range of rate sensitivity within the category. Franklin U.S. Government Securities and Fidelity Mortgage Securities have held up under rising rates in the past, she says.

Funds that invest in adjustable-rate mortgages, known as ARM funds, theoretically won't suffer the same sell-offs as fixed-rate securities since the coupon (a bond's yield at face value) will float upward when rates rise. Brian Carrico, who manages Pilgrim Group's ARM funds, recommends that they be used to diversify a fixed-income portfolio since they should hold up under several interest-rate scenarios. But these funds, which have a trailing-12-month yield of about 4.5% and are often sold as alternatives to money markets, may contain derivatives such as interest-only strips--complex financial instruments that can increase the funds' volatility, says Scott Lake, a mutual-fund analyst for Standard & Poor's Ratings Group.

To step out further on the risk spectrum but still avoid undue rate risk, consider high-yield corporates, otherwise known as junk bonds. These securities, and the funds that hold them, are considered to be less rate-sensitive because their price is determined more by the issuer's financial strength. In an improving economy, the balance sheets of junk-bond issuers should improve.

Or, to take U.S. rates out of the picture, Arnott recommends foreign bond funds. European rates are expected to decline over the next year, although long-term bond yields have recently shot up, along with those in the U.S., amid massive selling by managers of American pension and hedge funds. Also, there is currency risk, although fund managers try to hedge against it. Arnott likes T. Rowe Price International Bond or Fidelity Global Bond, both of which have yielded around 6.5% for the last year, but have recently dropped in share price.

Your stock portfolio could also benefit from a little re-jiggering if rates continue to rise. On Friday, Feb. 4, the Dow Jones industrials plunged 96 points in reaction to the Fed's short-rate hike. The hardest-hit stocks were banks, utilities, and insurance companies, which have benefited for several years from declining rates. But stocks that are cyclical in nature--that is, they improve during periods of economic expansion--should fare well.

RECOVERY READY. Terry Hamacher, managing director of equity funds at Prudential Securities, expects strong earnings growth in commodity-oriented companies that trade in steel and aluminum. Transportation and fertilizers are other areas she likes. She says to hold cyclicals not consumer stocks and expects more growth from foreign markets. But avoid emerging markets, which have been hit hard in recent weeks. If you own mutual funds, check their holdings to make sure they are not overly weighted in financials and are poised to take advantage of economic growth.

Initially, a rise in rates shouldn't signal the end of the bull market. Corporate earnings--a stock picker's main indicator--tend to increase in a stronger economy. The danger is that rates will rise so fast that fixed-income securities will start to look more attractive than stocks. Instead of the temporary correction that long-term investors should expect, that could lead to a full-fledged bear market.

Such a scenario would finally give everyone a chance to judge the staying power of eutual-fund investors. If they reversed the vast sums of money they have been pouring into funds and rushed to sell their shares, the market could fall fast and hard. And if that happens, or if rates just continue their upward trend for the next year or more, you'll be glad you took some action before the dust settled.

                  Intermediate and
      BONDS       long-term issues,
                  such as 10- and 30-year Treasuries. The longer a bond fund's
                  duration (the average time until holdings mature), the greater the
                  loss of principal when rates rise.
                  Companies that
      STOCKS      profited from the
                  decline in interest rates, such as banks, insurance companies, and
                  utilities. Avoid mutual funds with heavy weightings in the
                  financial sector. Also, rising rates are bad for emerging markets.
      BONDS       corporate and municipal bonds and mortgage-backed securities face
                  less interest-rate risk. Ultra short-term bond funds should yield
                  more than money-market funds.
                  Cyclicals, which
      STOCKS      show earnings
                  growth in periods of economic recovery. Analysts favor
                  construction, steel, aluminum, transportation, and fertilizers.
                  Look for mutual funds that contain these kinds of stocks.
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