Investing strategies to combat rising interest rates

For the past 30 or so years, interest rates have been declining. Back in the day, there were bond buyers who only bought – from me at least – long-term tax-exempt bonds. Also they were usually insured.

I don’t have too many of those clients on the books anymore, but some remain. That simple strategy has by all measurement been very successful for them. Think about it: Using that simple strategy has provided these investors with safe income with appreciation of the value of the bonds. No need or desire on their part to invest in stocks. Only long-term bonds.

I mention this scenario because of the length of time the decrease in interest rates has occurred. Thirty years is a long time. For many reasons, the coming increase in interest rates could – and may – occur over many years. Remember when the fiscal stimulus began a little more than eight years ago? Remember also the pundits who have expected much-higher interest rates over a short period of time? If you listened to their doom and gloom story and sold all of your bond investments, you lost out on the further decrease in interest rates and appreciation in bond values.

Because of demographics in our country, I see no reason to expect rapidly rising interest rates. Knee-jerk reactions as mentioned above are rarely successful in investing.

Here are a few suggestions to prepare a portfolio for slowly increasing interest rates.

Shorten maturities

If you own long-term individual bonds, start to shorten the maturities when bonds come due. Bonds continue to be called because of decreasing interest rates. As rates increase, they will not be called away as often. If an issuer has bonds out that are paying a higher rate than current interest rates, they will call them and reissue new bonds at a lower rate. Thus, they save themselves interest expense.

Conversely, if interest rates increase, they will continue paying on the lower rate. Your bonds will not be called and you will be stuck with them. If interest rates rise slowly as I expect, there is no need to drastically shorten your maturities. Instead of a 20-year maturity, perhaps shorten it to 15 years.

Bond mutual funds

As many readers know, I am not much of a fan of mutual funds that invest in stocks. There are better ways, in my opinion, to invest in stocks. Primarily via exchange-traded funds.

But in a slowly increasing interest rate environment, a good no-load, low-cost bond mutual fund makes sense. A good manager should be able to adjust the portfolio for stability and yield as rates increase.

A good bond-fund manager can give exposure to different types of bonds that most investors should not buy individually. These may include foreign bonds and even higher-risk bonds as well. I recommend staying away from very large bond funds and looking at smaller funds. They tend to be more nimble and don’t move the markets as much as a very large fund can when they buy or sell bonds for the fund.

If interest rates do begin to increase in a more rapid pace, one could consider bond swaps if they continue to hold longer-term bonds for whatever reasons. Swaps involve selling an existing bond, taking the loss and then reinvesting those proceeds in to similar bonds. Shorten the maturity whenever possible. If rates are rising rapidly that can be accomplished.

Bond ladders

Instead of keeping all of your bonds with long-term maturities, stagger them with five-, 10- and 15-year maturities. The faster the interest rates are increasing, the shorter the ladders could be. Even consider laddering bank CD’s if rates really begin to soar.

If rates do begin to soar, bond mutual funds will have a difficult time keeping up. Yes, they do replace older bonds with newer higher-yielding ones and on principal that should work. But, in my experience going back to the mid-1980’s, the problem with that thinking is that there will be many investors – many in panic mode – redeeming their mutual fund shares.

That will force the fund manager to send out proceeds to those investors, thus limiting the amount of funds available for reinvestment. These investors should at least go to shorter-term bond funds.

These are just a few simple suggestions for rising interest rates. As long as rates rise slowly, bond investors should be OK. But, if and when rates begin to jump, the game will change dramatically. This is when a good, seasoned adviser can add real value to your portfolio.

This story was originally published May 15, 2017 at 12:16 PM with the headline "Investing strategies to combat rising interest rates."