Over the past several years, we have seen case after case made on why interest rates need to increase or, alternatively, remain the same. After all, (short-term) rates have been at their historical lows since 2008. That is the year after the first iPhone was introduced! Due to the strengthening economy and market backdrop, I believe it is fair to say that the probability of rising interest rates in the very near future is fairly high. This should not discourage investor’s outlook, but rather serve as a realization that a different season is coming and to be prepared for the climate change.
The following are seven strategies investors should use in a rising interest rate environment:
1. Think Cyclical Stocks
Generally speaking, interest rates rise when the economy is doing well or the economic outlook is promising. When there is economic strength, businesses are more profitable and equity valuations increase. The stock market can be one of the easiest places to invest during this time. However, certain sectors will experience higher valuations than the others. Cyclical businesses like Industrials, Technology, Financials and Insurance tend to do well in rising rate environments. For example, Banks benefit due the widening spread between its lending and deposit rates, increased net interest margins and better loan quality.
2. The Old Greenback
Traditionally, the U.S. dollar does well in rising interest rate environments against other foreign currencies. International investors are attracted to loftier domestic rates in the marketplace. This capital injection increases the dollar’s value.
3. Shorten It Up
Let us all say it together, “As interest rates increase, bond prices decline.” While this is the mantra of bond investing, bonds should still be considered as a smart investment in a rising rate environment. Just by shortening the maturity (duration) of the security (portfolio), you will mitigate much of the price risk associated with increased rates, but still capture the income/cash flow stream that can then be reinvested at higher future interest rates.
4. Bond Laddering
A bond ladder is holding several bonds that mature at increasing intervals (i.e., every one, three, six, nine or 12 months). As interest rates climb, each individual bond that has matured is then purchased (reinvested) at the new, higher market rate.
5. Go With the Flow
Similar to the benefit of bond laddering, owning an investment with a floating rate or step-up coupon option, gives the investor the opportunity to participate in the rising rate environment. The yield is often higher and the cash flow from the variable/floating rate provides a nice hedge to the traditional, non-floating alternative.
6. Muni Love
While our national economy is improving as rates are climbing, our state and local governments are growing as well. As a result, revenues from these local areas improve, increasing the attraction and valuation of municipal bond investments.
7. Don’t Forget to Diversify
This goes without saying, this is how you win.
Be prosperous, my friends.
Derek Oglesby is a risk management consultant, providing advice for financial industry professionals through his namesake website DerekOglesby.com. Oglesby is a Charted Financial Analyst (CFA) with 17+ years of proven expertise in the finance and investment industry. He is most known for his expertise in the areas of quantitative analysis & financial modeling, fixed-income management, strategy and investment research. For more information about Derek Oglesby visit www.DerekOglesby.com or email derek@derekoglesby.com
