Beware of Higher Interest Rates

Rising inflation means rate hikes could come sooner than you think. Here's how to ready your portfolio

Evidence is mounting that investors should prepare themselves for higher interest rates. Surging oil and commodity prices are sparking inflation, pushing the Federal Reserve to warn that rate hikes could be coming soon. At least that was how markets interpreted vague comments from Federal Reserve Chairman Ben Bernanke on the subject on June 9.

"The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation," Bernanke said.

At least some market observers are skeptical. "They cannot be serious about tightening monetary policy as long as the credit markets remain fragile, home prices have yet to bottom, and labor markets remain weak," Ed Yardeni, president of Yardeni Research, wrote in a June 11 note. Goldman Sachs (GS) economist Jan Hatzius agrees, and Deutsche Bank (DB) economist Joseph LaVorgna expects a weak economy will force the Fed to cut interest rates early next year.

However, most of the market appears convinced rates are headed higher. Futures markets now say there is a more than 4-in-5 chance the Fed will raise its target federal funds rate by a quarter-percentage point in September, to 2.25%. With inflation heating up not just in the U.S. but worldwide, most assume the Fed and other central bankers will need to raise rates sooner or later. For investors, higher interest rates are not an appetizing prospect.

"It's bad for most asset classes," says Steven Medland, a financial planner at TABR Capital Management in Orange, Calif. Higher U.S. rates are bad for the price of bonds, and would hurt investments in gold and in U.S. stocks, he says. Also, higher rates might help the value of the U.S. dollar, which would hurt U.S. investors' returns in international investments.

So what can investors do if they're worried about higher interest rates? BusinessWeek asked market experts and financial planners for some advice. Here's what we found:

1. Stay away from long-term Treasuries.

Ten-year and 30-year Treasury bonds are likely to be most sensitive to an uptick in interest rates. With yields on long-term bonds unattractively low, a wide variety of experts warned investors away from the long end of the bond market—whether they're worried about higher interest rates or not. Rising Treasury yields will hurt the value of all bonds in the short term, but longer-dated bonds will be affected more than two- or five-year bonds, for example. "The longer the bond duration, the harder they're going to fall," says Cathy Pareto, a financial planner in Coral Gables, Fla.

2. You might want to wait before buying long-term certificates of deposit (CDs).

If you want to keep investments in cash, you're likely to get much better returns on a long-term CD if you wait several months or a year. Micah Porter, of Minerva Planning Group in Atlanta, suggests his clients invest in just one-year CDs for now. "We think if we hold out for a year, we can get much better interest rates than we can now," he says.

3. If you're investing in bonds for the long term, higher rates are actually a good thing.

Rising interest rates are likely to cause the market value of your bond investments to fall. However, over the long term higher rates boost your returns.

If you invest in bonds, "you actually want those interest rates to rise because you're a lender," says Milo Benningfield of Benningfield Financial Advisors in San Francisco. "[It] can be painful in the short term, but in the long term, you're better off." For this reason, many planners put their clients in short- and intermediate-term bond funds.

As rates rise, "those bond funds are constantly buying new bonds, reinvesting their proceeds at a higher rate," Medland says.

Also, if you own individual bonds and plan to hold onto them until maturity, the decline in their market value may be irrelevant to you. You'll still get paid the same interest, and you'll still get your principal back.

4. Hire the professionals.

Many financial planners, who don't see the value in actively managed equity mutual funds, say investors can get a boost by investing in bond funds run by fixed-income experts. The recent volatility of bond markets has created opportunities for investors who really know what they're doing, Minerva's Porter says. He prefers "bond managers who can go anywhere"—who can invest wherever they see opportunities around the world—and recommends the Loomis Sayles Bond Fund (LSBRX) to his clients.

5. Don't bank on a dollar rally.

If U.S. interest rates rise, but other countries' rates hold steady, then theoretically, the value of the U.S. dollar should rise. But other central bankers are also expected to raise interest rates. Uncertainty about interest rates makes the tough game of predicting currency movements even more difficult.

Bill Larkin of Cabot Money Management believes that because of credit problems and the weak economy in the U.S., the Federal Reserve is likely to react more slowly to the inflation threat than foreign central bankers. So he suggests buying foreign government debt adjusted for inflation. However, he acknowledges a strengthening dollar could hurt the returns of that investment strategy.

6. Don't make any bold moves.

"Trying to forecast [interest rate moves is] like trying to forecast the weather in San Francisco," Benningfield says.

There may be a consensus that higher interest rates are on the way, but many disagree, arguing rates could fall further, at least in the U.S. Others think the Fed is stuck with rates at this level for a long while. Cutting rates will stimulate inflation, while raising rates "will stifle any economic recovery," says James King, president of National Penn Investors Trust (NPBC).

If investors are worried about higher interest rates, there are ways they might adjust their portfolios to avoid big risks or hedge against potential losses. But an uncertain economic environment leaves investors with no sure bets.