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How to Invest in a Rising Interest Rate Environment

Published: 02/18/2011 by Dominick Paoloni, CIMA

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At the beginning of December, President Obama agreed to cut a deal with the Republicans. The deal, which included a two-year extension of the Bush tax cuts for all Americans, a higher estate tax exemption, and increased spending through unemployment benefits and tax credits, immediately sparked a sell-off in the bond market and drove up bond yields. Could this be the straw that breaks the camel’s back for bonds? Or rather, the pin that pops the bond bubble?

The all-time historical interest rate lows have helped the equity markets trend up through these very fragile economic times. Recently, the Federal Reserve bought massive amounts of treasuries from the banks through quantitative easing, which allowed the banks to unload treasuries without flooding the markets and kept yields low by reducing the supply. This time, however, could be different. The global markets seem fed-up with the US’s refusal to reign in its massive debt, and another $900 billion charged to the country through the Bush tax cut extension does not signal a country willing to make the necessary sacrifices.

So if yields continue to rise, what investments will do well and protect your portfolio from rising interest rates?

Floating Rate Bank Loans
While the price of traditional fixed rate bonds decline when interest rates rise, bank loans tend to hold their value. The rate of interest charged on these floating rate bank loans are tied to the London Interbank Offering Rate (LIBOR) and tend to reset as frequently as once a month or once every three months. As a result, the inverse relationship of price to yields doesn’t exist with these loans. “Senior” floating rate bonds hold a senior position in the capital structure, their priority over conventional bonds in a default scenario helps manage downside risk if the economy takes a turn for the worst. They recovered from the recent downturn more quickly than high yield bonds and are less volatile. A number of mutual funds can be used to invest in floating rate bank loans, however, many require a minimum holding period of 3-6 months. IPS invests in floating rate bank loans through a closed end fund, which allows me to be more tactical than a mutual fund with a minimum holding period. I have found this asset class to be a very good hedge against rising interest rates.

Oil
Historically, the price of oil is highly correlated to bond yields. Energy is one commodity that affects every company in one way or another. For example, the price of wheat makes a greater impact on agriculture stocks, but oil influences everything from the cost of electricity and heating, to the cost of production and transportation. When the price of commodities, and particularly oil, is on the rise it signals that inflation is starting to become apparent.  The day-to-day price fluctuations won't cause inflation fears, but the long-term trend will. If the price of oil has been steadily increasing, it could cause investors to be fearful that inflating energy prices will cause inflation which devalues bonds. The question is whether the dog is wagging the tail or the tail is wagging the dog. In either case, the correlation between oil and bond prices tend to be negative to low, which makes this a good hedge in your portfolio. You can invest in oil through an ETF, ETN, or oil company stock; however, I have found oil companies to move more with the stock market than with the price of oil.

Real Estate and Gold
Both real estate and gold are hard assets and tend to have a positive relationship during periods of inflation, when the government enacts tight monetary and fiscal policy. However, this is not the case today, when the government pegs short term rates to zero and keeps monetary policy loose. Not only are gold and bond prices highly correlated today, but real estate currently has its own set of economic problems that override its historical relationship to yields. I find both gold and real estate to be weak hedges right now to higher bond yields.

Treasury Inflation Protected Securities (TIPS)
TIPS are inflation-indexed bonds issued by the US Treasury by increasing the principal by the consumer price index. In theory they provide value in inflationary environments; however, I have found the CPI underreports and does not reflect the true measure of inflation. As a result, TIPS are not a true counterweight to rising interest rates and are currently highly correlated to government bonds. At this time, TIPS are a poor hedge to rising yields.

A rising interest rate environment presents a special set of investment concerns, and I believe that some of the hedges that worked in the past will not provide the same value. Floating rate bank loans and oil continue to counteract rising bond yields, but I do not expect real estate, gold, and TIPS to hedge as they have historically. Equities have responded positively to the tax extension, which should add to the GDP going forward and has shown to be a strong diversifier for now to increased bond yields. Be warned, however, that bonds and equities haven’t always hedged as we expect. Remember 2008? Investors must continue to monitor correlations between assets. Investing has become a contact sport, and any investor not paying attention will get knocked down.

*This article is not a recommendation to buy or sell and should not be considered investment advice. Please consult IPS or another financial advisor before making any investment decisions.