How to prepare your portfolio for rising interest rates

Increasing yields can bring both risk and reward for these stocks, but that doesn't mean you have to miss out on earning consistent dividends.

By StreetAuthority Jun 13, 2013 8:41AM
A bird nest full of money © David R. Frazier Photolibrary, Inc., AlamyBy David Sterman

As interest rates collapsed in the past few years to multi-decade lows, investors had no choice but to flee low-yielding government bonds and bank CDs for higher-yielding, dividend-paying stocks. From master limited partnerships (MLPs) and real estate investment trusts (REITs) to foreign government bonds, it's been an era of profitable investing.

Yet signs are emerging that this trend may start to reverse course.

The yield on the 10-year Treasury note has spiked higher since the beginning of May to roughly 2.2%, and if we continue to see robust monthly employment reports, then these rates will probably climb steadily higher as the year progresses.
Simply put, the economy is getting healthier. Even given the likelihood that the Federal Reserve will keep its benchmark interest rates quite low for a few more years, the longer-term bonds, which are influenced by economic trends, have begun to anticipate a broader upturn.

So are the MLPs, REITs and other dividend payers likely to suffer if investors start to see attractive yields in the safety of government bonds and bank CDs? Not necessarily. But you need a keen understanding of the factors behind the rate changes, as they will bring disparate effects to different types of asset classes.

Before digging deeper, understand that the yield on the 10-year Treasury is likely to rise at a slow pace, and it could be a year or more before that figure moves past the 3% mark. The only concern is that the Fed's massive pump priming (known as quantitative easing or QE) is so unprecedented that we don't know how bond prices will react when the Fed starts to wind down the program. It could lead to a bit of chaos, which the bond market hates. Still, as long as the 10-year Treasury remains below 3%, it's premature to get too alarmed about the recent rate rise.

The cost of money
Putting aside for a moment the question of relative yields between bonds and stocks, you should be more concerned about which companies will be hurt or helped by rising rates. We've already seen potential losers in the group of mortgage REITs such as Two Harbors Investment (TWO) and Annaly Capital (NLY), both of which have fallen more than 10% in the past three months. These firms take advantage of low borrowing rates and garner profitable spreads by reinvesting their funds into higher-yielding mortgage-backed securities.

Traditional REITs, many of which deploy debt leverage to boost returns (or at least on properties that carry variable interest rate debt), are also falling out of favor right now. In just the past four weeks, a number of REITs have fallen more than 10%, including:
  • Cousins Properties (CUZ)
  • Duke Realty (DRE)
  • National Retail Properties (NNN)
(Besides traditional yield plays, homebuilders will also feel the pain of rising rates as pricier mortgages narrow the pool of potential homebuyers. Shares of D.R. Horton (DHI), for example, have slid 10% in the past month.)

Higher rates will be felt most heavily by companies that carry variable rate debt, though you need to research and find out whether a specific company's floating rate debt is tied to LIBOR, which is likely to stay low for a while longer, or high-interest credit lines that are more closely aligned with 10-year bond rates. Rising variable interest rates will start to lead to lower earnings for highly leveraged companies.

The winners
Conversely, any companies that have suffered from low returns on their cash are bound to benefit. Charles Schwab (SCHW) for example, has made few profits on its money market funds or on the cash balances it holds for clients. Rising rates would help boost Schwab's core earnings power.

In a similar vein, insurance companies will also soon start earning more money on their hefty cash balances. I looked at this group a few weeks ago and noted that what had been a big headwind, pushing their shares below book value, could soon become a tailwind.

Risks to consider: The yield on the 10-year Treasury has spiked higher in a short time on several occasions in the past, so you may want to see yields pushing above 2.5% -- a level not seen in nearly two years -- before making major portfolio moves. Still, this is a good time to think about the steps you'll take in such a transition.

Action to take: The long bull market in bonds that began in the early 1980s appears to be winding down. Although dividend-paying stocks of all stripes have benefited, it's time to separate the field into winners and losers by looking at how interest rates affect each of these investments' earnings. Any company that uses very low interest rates to juice profits has probably seen a peak in profits, and smaller dividends may be looming ahead.

Add in the fact that rising fixed-income rates lessen the appeal of riskier stocks, and a tide may be turning. Still, it will be quite some time before fixed income investments offer the 4% or 5% yields that many crave.

More From StreetAuthority

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of NLY, TWO in one or more of its "real money" portfolios.
34Comments
Jun 13, 2013 10:50AM
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Ok, I don't plan to play with bonds anytime soon.  But if I were how would this author suggest I do it?  He gave no real advice.  For me buying bonds even if rates rise 50% from this level would be foolish.  I believe the Fed money printing guarantees higher interest rates and higher rates mean the value of bonds go down.  Why would I buy into that?  And Obama's economy-wealth-prosperity killing 20 trillion on its way to 25 trillion dollar debt will also drive rates higher as the world tires of taking on more and more risk and as they see U.S. inflation they will demand even higher rates.

 

I can not see owing bonds for perhaps the next ten years as we see how the Obama disaster unfolds.

Jun 13, 2013 12:05PM
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We now modify our core investing strategies based on what we think the government will do next.

 

A sad time indeed.

 

 

Jun 13, 2013 12:09PM
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When the IDIOT Ben starts to wind down QE3 ? He created a monster in the box ! Wall street likes all this free money and does not want to go back to sound investing principals . < You can tell by their whining and crying. < Its like people crying about mortgage rates rising to 4% ? ARE YOU IDIOTS lost .. 5-7% int rates on a mortgage, with 20% down and a credit rating of 750 or better is , and should be the only way to get a mortgage. No more PMI insurance < KILL THAT... And start paying savers instead of borrowers.. So the market drops 3000 pts so what . The scumbags on wall street will get over it in a few weeks. Lets get rid of this QE B.S. and start putting the power back into the US dollar. BTW if the wall street banks fail now they are truly on their own ! < We need true capitalism back , not this socialized wall street bailouts on the US Tax payer like we have today. Too big to fail mantra should go bye bye.
Jun 13, 2013 10:59AM
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V_L,

 

Stocks are a pretty good hedge against inflation.  If Coke sells a 12 oz drink for 50 cents and makes a nickel on it, and then we have 100 % inflation, then it will sell the same drink for 100 cents and make a dime.  All else being equal, ie the PE ratio staying the same, the price of the stock doubles.  Of course the reality is that you have gained nothing as the buying power of the value of your stock has remained the same.  And of course if you sell, Uncle Sam will take a cut of your BOGUS gain.  (This is why capital gains should be indexed to inflation and exactly why they never will be).  Really this is the exact same logic used to owe gold as a hedge against inflation, and you still have to pay taxes on gold gains.  One big difference is the INSANE commissions you have to pay on gold purchases and sales.

 

Back to stocks.  Of course not all stocks will have complete pricing power to offset inflation, but most have to come pretty close.  Secondly, a high inflationary economy ususally has slower economic growth and this can be a drag on stocks and a drag on their ability to completely offset inflation.  All said and done stocks are a petty good hedge against inflation and should over a long term do better than gold.  Obviously, fear has driven gold to preform very well, but long term their is no mechanism to drive gold to outperform inflation and stocks benefit from growth on top of inflation pricing.  Bonds going forward from here will just be death to your economic health.

Jun 13, 2013 1:43PM
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Curious will they finally raise the interest rate in banks saving accounts???

 

It is getting old having bankers use our funds for loans while only giving a half a penny back in interest!!!!! 

Jun 13, 2013 12:53PM
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The inflation rate is already rising.  The government (Republicans, Democrats and Obama) is in denial of this fact.  Just like in 2008 when the government kept denying a recession had begun, until the economy completely to hell. 

 

I feel sorry for whom ever the next President is, democrat or republican.  They will be stuck with high inflation, out of control spending and budget cuts that Obama refuses to make. 

Jun 13, 2013 12:27PM
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Old-Air,

You will get killed!  If your 30 year munis pay you 3.5% or 4%, ask a broker what that bond will be worth in 5 years when similar bonds are paying you 6%.  Your $100,000 bond portfolio will be worth about $60,000.  I could do the math , but that is a guess.  Even if the number were $80,000, does that sound like a plan?

 

If you must go fixed income, go short term bonds.  You might only get 1.5% but when interests return to 5% you can buy bonds then .... maybe.

Jun 13, 2013 3:28PM
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Get rid of Bernanke and get some one in there that cares about investors instead of the banks.
Jun 13, 2013 12:12PM
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If you were interested in buying bonds now, I would lean towards short term bond funds.  They don't pay out as much as longer term funds right now, but they will trend upwards as the interest rates rise because the fund will be able to replace current low interest bonds with higher interest bonds as they mature.

Therefore the rate of return will increase as will the capital appreciation of the fund.
Jun 13, 2013 12:13PM
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My 5 year CD just matured and was paying 4.75% This money was in my SAFE bucket of invest ments.. There is a five year CD paying 1.5% with only 2months early withdrawal  penalty. There are zero couple bonds paying 3.6% for 6 year term. Then there are fixed annuities paying 3.2% for 10 years. Wish I knew when and how much interest rates might rise. Back in 2010 I was sure rates were going up. I am 65 and this money is in my lower 1/3 bucket of safe investments. Don't need the money to live on cause my retirement income pays the bills with cola adjustments. Got to make a move soon.

Jun 13, 2013 2:47PM
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sadsack1964,

 

This is typical.  The Democrats make a big mess and then the Republicans have to clean it up and take the heat for doing the right thing.  Obama knows that he can pile on 10 or 12 trillion in debt and the wheels will not fall off his bus or the economy until he is out of office.  The sht will hit the fan, as you say, in the next administration.  Typical, Carter guts the military, and Reagan came in fixed it and buried the Soviet Union.  Clinton comes in, increases domestic spending, guts the military again using Reagan's "peace dividend".  Obama continues to gut the military and we are now unable to fight a two front war.  What will come of that will not be good and Republicans will have to fix it, and take the heat for the spending.  The Democrats even know this is true, but it fits their agenda, expand the Welfare state at the expense of security, and then let the Republicans take the heat for fixing that problem, all the while the Democrats pocket the expansion of the state.

 

Take missle defense.  Reagan started it.  The Democrats have attempted to defund it at every turn.  Obama guts the program in Europe.  And then when N. Korea acts up, the Democrats take credit for being able to deploy missle defenses in the Pacific.  Typcial.  And on and on and on.

 

So once again, the Democrats maintain and expend Socialism with Debt, and Debt, and Debt.  And they know there will be hell to pay on someone else's watch.  And they know the American people are too stupid to look at cause and affect, and to look in the rearview mirror.  And they know that it will be impossible to turn back their socialist expansion.  So Republicans will get the blame for Obama's disaster.

Jun 13, 2013 11:41AM
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I've been struggling with this question as I approach retirement in 2015. One step I have made is to shift about 20% of my non-retirement fund (401K) holdings into State/Muni Bond funds of the state I will be retiring in. Over the last 6 months the share price has dropped a few pennies/share but re-investment of distributions/dividends has resulted in a 2% tax free gain on the original investment, with a rebound on the share price it would be closer to a 5% gain.
Jun 13, 2013 1:17PM
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If you're worried about the fluctuations, try looking into index strategy annuity which protects your principal but at same time if the market does well you can mirror a percentage of it.  Last few years, return on it has been averaging about 9% with no downside risk if the market does crash.  For those who are young and healthy, look into GIUL as diversification using the same strategy but TAX NEVER loan provisions.   
Jun 13, 2013 3:32PM
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"Be a Delusional Psychopath" or a Broke beggar living under the bridge, in a box....

 

Is this really a Choice I have to make today?? 

Jun 13, 2013 5:25PM
Jun 13, 2013 4:31PM
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MLPs, LPs,Trust and even REITS(when favoable conditions exist) are pretty good bets on high dividend returns...Different type taxing conditions...

Get good advice, do your research, and maybe consult a tax advisor.

Jun 13, 2013 8:26PM
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"The Democrats make a big mess, and then the Republicans have to clean it up"

 

That's takes a lot of balls to make a broad brush statement of that sort.

 

Better CHECK....the Facts and Logic, nary get labeled a lunatic.

 

BTW...We really shouldn't be fighting any Wars, unless beneficial to all Americans..These are not.

Jun 13, 2013 4:26PM
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For you guys/gals contemplating or about to retire...

Number one thing of "Importance.".....Are you ready to retire ?? It's a different life, first of all.

The one waiting for/or at about 65, you are gaining every month on what you can draw on SS.

Both of you should realize and will, how much money you will be saving by retiring...

Make a list, add it up. Providing you do not have any "major debt" such as Mortage,CCs or New cars.

Figure in all forms of income, that you might be recieving(including any windfalls, Estates, etc.).

 

We retired several years before 62, then took SS as soon as possible; We don't regret it.

Putting safe back ups into long term low payers, I never considered. Usually about 6-13 months.

Maybe up to 3 years on a good rate...Exception: Locked in maybe longer terms on monies for kids, g-kids on an IRA or CDs; Being left to them. 

Jun 13, 2013 10:43AM
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How to have anything left after the false Dollar finally crashes: CASH OUT of stocks, bonds and real estate beyond your own home. Re-invest in your local community so it has everything you will need as Kool Aid flushes out of the global economy and Reality is restored. Better to be admired by many for your commonsense as we all reset, than to be a delusional psychopath.  
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