How to Fed-Proof Your Portfolio

Improve your odds of making money once the Federal Reserve starts hiking interest rates.

By now, it’s a well-worn question: How will the markets react when the Federal Reserve starts hiking interest rates? After all, there is widespread agreement that cheap money has impacted the price and attraction of a wide array of investments, ranging from dividend-paying stocks and bonds to master limited partnerships and real estate. If the Fed abandons its long-standing policy of keeping short-term interest rates near 0%, it could set off a tectonic shift that rattles markets, nicking some investment categories while lifting others. So the next question becomes: Can you – and should you – Fed-proof your portfolio?

Unfortunately, the current economic and investment environment makes that question uniquely difficult to answer. That’s partly because economists and market seers have been anticipating a rate increase for well over a year, and they’ve advised their clients to prepare their portfolios. As a result, analysts say, investors have already “picked over” some categories that might otherwise be considered attractive in a rising-rate environment.

Then, too, it’s not clear that the economy is strong enough to warrant more than one 0.25-percentage-point increase in short-term interest rates this year. And the prospect of even that small hike has come into question following China’s move to devalue its currency, which suggests that the country’s economic growth is decelerating at a far faster pace than most observers have expected. Regardless, Kiplinger believes the Fed remains on track to raise the federal funds rate – the rate banks pay for overnight deposits – in either October or December.

Such a modest rate increase calls for a modest reaction, says Russel Kinnel, director of mutual fund research at Morningstar. “We may have a very gradual rate rise, so it may not be something that you need to build a huge line of defense for.” That said, if you’ve done nothing to Fed-proof your portfolio so far, now may be the time.

What to Do With Your Bonds

The Fed controls only short-term interest rates. Investors set yields and prices on debt securities through their activities in the bond market (prices and yields move in opposite directions). Although short-term and long-term rates may not move in lockstep, the presumption is that if the Fed boosts rates, longer-term bond yields will eventually follow, especially if investors sense that the economy is strengthening, a development that could fuel inflation.

Given today’s paltry yields, it won’t take much of a rise in rates to turn a bond’s return negative, says Russ Koesterich, global chief investment strategist at BlackRock. For example, the duration of the benchmark 10-year Treasury bond is currently 8.7 years (duration is a measure of interest-rate sensitivity). The figure implies that if long-term interest rates rise by one percentage point, the value of the 10-year Treasury will fall by 9.0%. If rates rise by 0.25 percentage point, the bond could be expected to lose roughly 2.2%.

If you fear the Fed, the obvious move is to pare back long-duration bonds and funds that invest in them. Even if a Fed hike affects short-term bonds more than longer-term IOUs, the shorter-term bonds are less risky. Our top pick is Vanguard Short-Term Investment-Grade (symbol VFSTX). The fund, a member of the Kiplinger 25, has two-thirds of its assets in bonds rated single-A or higher, charges just 0.20% a year, yields 1.8% and has an average duration of 2.6 years. An intriguing choice is Sit U.S. Government Securities (SNGVX), which invests mostly in government-backed fixed-rate mortgage securities. Although the fund charges more (0.80% a year), it yields 2.3%, and its average duration is a mere 0.9 year.

Want an investment that might actually benefit from rising short-term rates? Rick Vollaro, chief investment officer at Pinnacle Advisory Group, suggests floating-rate bank loan funds. These funds buy short-term loans that banks make to borrowers with below-investment-grade credit ratings. The loans are tied to a short-term interest rate – the London Interbank Offered Rate, or Libor – and typically reset every 30 to 90 days. Thus, as short-term rates rise, investors in these loans would expect to earn higher returns. And if rising rates are a sign of an improving economy, the risk that borrowers might default diminishes, enhancing the attractiveness of these loans.

Two solid choices among bank-loan funds are Fidelity Floating Rate High Income (FFRHX), yielding 3.7%, and T. Rowe Price Floating Rate (PRFRX), yielding 3.6%. The former charges 0.69% annually, the latter 0.85%. Note that although banks have higher standing than bondholders in case a borrower gets into trouble, that didn’t prevent bank-loan funds from taking it on the chin in 2008. The average bank loan fund lost nearly 30% that year, and the Fidelity fund dropped 16.5%.

We would avoid high-yield bond funds. An improving economy normally bodes well for junk bonds, which are issued by young, small, troubled or highly leveraged companies. However, energy companies account for a substantial portion of junk bonds: 13% in one Merrill Lynch high-yield bond index. With oil prices having plunged to less than $50 a barrel, many energy companies may not make enough money to meet their debt obligations. That could make investing in junk bond funds even riskier than normal.

Suppose you want to eliminate virtually any chance of losing money. In that case, build a ladder of individual short-term bonds or certificates of deposit. That way, if rates rise, you’ll soon have money coming due for reinvesting in bonds or CDs with higher yields. And in the meantime, you’ll earn a bit more than you could get with a money market fund or Treasury bills. Consider dividing your fixed-income money between debt securities coming due in six months, one year, two years and three years. Limit your investments in things other than CDs or Treasuries to bonds issued by high-quality firms.

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How to Play the Stock Market

Investors scratching for reasonable income at a time of rock-bottom interest rates have flocked to utility stocks and real estate investment trusts for their generous dividend yields. But the threat of higher interest rates has already caused these investments to lose their luster.

The two sectors have exhibited their interest-rate sensitivity for much of 2015. While long-term bond yields were rising for much of the first half of the year, both of these groups were sinking. From January 29 through June 30, the Dow Jones Equity REIT Index tumbled 14% and the Dow Jones Utility Average sank 16%. Since then, as bond yields dropped, partly in response to the turmoil caused by China’s devaluation of the yuan, the real estate group has gained 6% and the utility average has advanced 9%.

However, you shouldn’t assume that higher interest rates will cause the broader stock market to tank. That’s because the benefits many companies would reap from a stronger economy would outweigh the negatives of higher borrowing costs. That’s especially true today, when so much of corporate America is flush with cash. In any case, since 1946, the S&P 500 has on average gained 6.2% in the 12-month period after the Fed has begun to raise rates, according to S&P Equity Research.

One industry that can profit from rising rates is the banking sector. Banks benefit because higher rates go hand in hand with a stronger economy, which typically leads to more demand for loans. Moreover, a better economy spells fewer bankruptcies and loan defaults, meaning fewer write-offs of bad debt. Finally, banks earn the bulk of their income on the spread between the cost of their deposits and the amount they can charge for loans. Loan charges typically rise quickly after the Fed hikes rates, but deposit rates tend to rise slowly.

That said, investors have been buying bank stocks for months in anticipation of rising rates, and that has left the shares of most of the big national banks, including Bank of America (BAC), Citigroup (C) and Wells Fargo (WFC), at or near their fair values, says Morningstar.

You can still find some bargains among large regional banks, says Morningstar. It likes Cincinnati-based Fifth Third Bancorp (FITB), which has $142 billion in assets and 1,300 branches, mainly in the South and Midwest. Minneapolis-based U.S. Bancorp (USB), with more than $400 billion in assets, is also worth considering, says Morningstar. U.S. Bancorp boasts nearly 3,200 branches, mainly in the West and Midwest.

Another way to play the group is to invest a small percentage of your assets in an exchange-traded bank-sector fund. Consider iShares US Regional Banks ETF (IAT), whose top holdings include smaller regional banks, such as U.S. Bancorp, PNC Financial Services Group (PNC) and BB&T (BBT). Annual expenses are 0.45%.

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