Beware of Higher Interest Rates

Rising inflation means rate hikes could come sooner than you think. Here's how to ready your portfolio

by Ben Steverman

Evidence is mounting that investors should prepare themselves for higher interest rates. Surging oil and commodity prices are sparking inflation, pushing the Federal Reserve to warn that rate hikes could be coming soon. At least that was how markets interpreted vague comments from Federal Reserve Chairman Ben Bernanke on the subject on June 9.

"The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation," Bernanke said.

At least some market observers are skeptical. "They cannot be serious about tightening monetary policy as long as the credit markets remain fragile, home prices have yet to bottom, and labor markets remain weak," Ed Yardeni, president of Yardeni Research, wrote in a June 11 note. Goldman Sachs (GS) economist Jan Hatzius agrees, and Deutsche Bank (DB) economist Joseph LaVorgna expects a weak economy will force the Fed to cut interest rates early next year.

However, most of the market appears convinced rates are headed higher. Futures markets now say there is a more than 4-in-5 chance the Fed will raise its target federal funds rate by a quarter-percentage point in September, to 2.25%. With inflation heating up not just in the U.S. but worldwide, most assume the Fed and other central bankers will need to raise rates sooner or later. For investors, higher interest rates are not an appetizing prospect.

"It's bad for most asset classes," says Steven Medland, a financial planner at TABR Capital Management in Orange, Calif. Higher U.S. rates are bad for the price of bonds, and would hurt investments in gold and in U.S. stocks, he says. Also, higher rates might help the value of the U.S. dollar, which would hurt U.S. investors' returns in international investments.

So what can investors do if they're worried about higher interest rates? BusinessWeek asked market experts and financial planners for some advice. Here's what we found:

1. Stay away from long-term Treasuries.

Ten-year and 30-year Treasury bonds are likely to be most sensitive to an uptick in interest rates. With yields on long-term bonds unattractively low, a wide variety of experts warned investors away from the long end of the bond market—whether they're worried about higher interest rates or not. Rising Treasury yields will hurt the value of all bonds in the short term, but longer-dated bonds will be affected more than two- or five-year bonds, for example. "The longer the bond duration, the harder they're going to fall," says Cathy Pareto, a financial planner in Coral Gables, Fla.

2. You might want to wait before buying long-term certificates of deposit (CDs).

If you want to keep investments in cash, you're likely to get much better returns on a long-term CD if you wait several months or a year. Micah Porter, of Minerva Planning Group in Atlanta, suggests his clients invest in just one-year CDs for now. "We think if we hold out for a year, we can get much better interest rates than we can now," he says.

3. If you're investing in bonds for the long term, higher rates are actually a good thing.

Rising interest rates are likely to cause the market value of your bond investments to fall. However, over the long term higher rates boost your returns.

If you invest in bonds, "you actually want those interest rates to rise because you're a lender," says Milo Benningfield of Benningfield Financial Advisors in San Francisco. "[It] can be painful in the short term, but in the long term, you're better off." For this reason, many planners put their clients in short- and intermediate-term bond funds.