Higher returns

There is some good news: With higher rates, stock and bond returns should improve.

To figure out how interest rates affect gains, Elroy Dimson, an emeritus professor of finance at London Business School who researches the history of financial markets, and his colleagues Paul Marsh and Mike Staunton, looked at stock and bond performance from 1900 through 2012 in 20 countries, including the U.S., U.K., Japan and other developed and emerging markets.

Over those 113 years, average five-year returns for stocks and bonds were better when rates were elevated.

For example, when inflation-adjusted interest rates were between 0.1 and 1.5 percent -- the range in which U.S. rates are now -- stocks had an average annual total return, including dividends, of 3.9 percent after inflation over the subsequent five years, while bonds were flat.

In an interest-rate range of 1.5 to 2.8 percent -- where rates were before the financial crisis -- stocks historically have returned 4.9 percent annually over the next five years, while bonds have returned 1.5 percent.

"When interest rates are low, you've gotten rotten returns on bonds and rotten returns on equities," Prof. Dimson says.

While higher rates can improve returns over the long term, there can be a lot of pain along the way. From 1963 through 2012, 10-year Treasury yields rose on average during 26 calendar years and fell in 24 years before adjusting for inflation, according to Federal Reserve data.

In an average rising-rate year, large-company stocks delivered returns, including dividends, of 8.1 percent, before inflation, according to a Wall Street Journal analysis of U.S. data from research firm Ibbotson Associates. That is 6.5 percentage points less than such stocks earned in falling-rate years.

Because long-term government bonds take the longest to mature, rising rates hurt such bonds the most. During a rising-rate year, long-term government bonds have returned an average 2.7 percent, 11 percentage points less than when rates fell.

Still, even in bonds, there are some steps you can take to improve your returns.

Impact on bonds

Investors might be tempted to move the bulk of their fixed-income portfolios into cash or very short-term bonds. Such a move gives protection from rising rates but also gives up the income and diversification benefits bonds provide. There are better strategies.

To gauge a portfolio's sensitivity to interest rates, investors use a measure called "duration." A portfolio with an average duration of five years, for example, would be expected to lose 5 percent in price if rates were to rise by one percentage point immediately.

However, as the market begins to anticipate the Federal Reserve raising short-term interest rates, investors might find that portfolios with similar durations aren't affected equally, says Jonathan Lewis, chief investment officer at Samson Capital Advisors in New York, which manages $7 billion.

That is because bonds that mature in between four and five years could see rates rise -- and prices fall -- more rapidly than both shorter- and longer-term bonds, he says. In other words, though a duration measure assumes that rates on bonds with any maturity rise equally, in reality, intermediate bonds could get hit hardest.

To achieve duration of four to five years without investing in bonds with those maturities, bond investors can use a "barbell" of shorter-term bonds and longer-term bonds, which together can average out to the same level, Mr. Lewis says.

Mutual-fund investors can see how the maturities of their funds' bonds are distributed by looking at the "portfolio" tab on the fund's page at Morningstar.com.

By the same token, investors would be well served by venturing away from Treasurys to other relatively safe bonds with slightly higher payouts, Schwab's Jones says. That means taking a look at investment-grade corporate bonds and municipal bonds, she says.

One low-cost option is the Vanguard Intermediate-Term Corporate Bond ETF (VCIT), which yields 3.5 percent and has an annual expense ratio of 0.12 percent.

Municipal bonds, whose income is exempt from some taxes, right now have about the same interest rate as Treasurys, making them attractive to high-income investors in taxable accounts, Jones says.

Historically, the highest-rated muni bonds' tax-advantaged status has caused their yields to be lower than those of Treasurys. Muni yields are now even with those of Treasurys in part because of legitimate worries of default for bonds issued by Detroit, Puerto Rico and a few other troubled areas, but thus far, those problems have remained isolated, Jones notes.

Finally, though rising rates will lead to higher mortgage prices, that shouldn't necessarily cause home prices to drop, says Thomas Lawler of Lawler Economic & Housing Consulting in Leesburg, Va.

Historically, there's been very little relationship between home prices and mortgage rates, all else being equal, he says. Of course, if higher rates come because of higher inflation or rising incomes, that could lead prices higher, he says.

In the short term, Lawler says, home prices might rise more slowly as institutional investors slow their buying and new-home inventory starts to hit the market.

Yet he says it still is a decent time to buy a home for buyers with good credit who plan to live there for a number of years and aren't thinking of their home as an investment.

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