How to Prepare Your Portfolio for Higher Interest Rates

Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

U.S. Fed Chairmen Ben Bernanke has signaled he's turning off the easy money taps. That means higher interest rates and disappointing returns for bond portfolios. 

So how do legendary bond investors like Bill Gross and Daniel Fuss prepare their portfolios for higher interest rates? They cut down on risk. 

Reduce duration

Duration is a measure of sensitivity a fixed-income security has to changing interest rates. The higher the duration, the greater the risk. During periods of rising rates, professionals tighten up on their positions, reducing the duration of their portfolio. 

For example, consider hypothetical returns for two popular bond ETFs: 

iShares Trust Barclays 20+ Year Treasury Bond Fund (NYSEMKT: TLT) invests in U.S. Treasury bonds with an average duration of 16.5 years. If interest rates were to increase 2% - well within historical averages - the fund would lose 33% of its value. It would take nearly a decade of interest coupons to recover your losses. 

As is often said, with a yield of only 3.3%, buying long-term bonds is a bit like picking up nickles in front of a steamroller. 

In contrast, a short-term bond fund like iShares Barclays 3-7 Year Treasury Bond Fund (NYSEMKT: IEI) has much less exposure to rising rates. With an average duration of 4.4 years, a 2% interest rate hike would result in a loss of only 8.8% of the fund's value. In addition, short-term bonds will mature quickly and principal can be reinvested at higher rates. 

Clip those coupons

Avoid zero coupon bonds - debt instruments offer no regular interest payment but rather pay investors a lump sum at maturity. The advantage of these types of funds is that they have no reinvestment risk; the chance that future coupon payments will not be reinvested at the same rate as when the bond was initially purchased. 

That's not a problem for zero-coupon bonds. Funds like the PIMCO 25+ Year Zero Coupon U.S Treasury Index ETF  (NYSEMKT: ZROZ) were the top performers during the 30- year bond bull market because returns were locked in. 

But in a rising rate environment, that advantage becomes a liability. These type of securities will underperform the most as coupons can't be reinvested at higher rates. Of the bond funds mentioned in this post, ZROZ is by far the riskiest. With an average duration of 27.4 years, a 2% increase in interest rates would result in a nearly 55% draw-down. 

So clip those coupons. 

Stick to floaters

No, not dead fish - floater is industry slang for variable interest rate notes. With these securities, coupon payments are adjusted, usually every six months, depending on the prevailing interest rates at the time. This protects investors against rising rates. 

The easiest way to buy variable rate securities is through the iShares Floating Rate Note Fund (NYSEMKT: FLOT). It offers a yield of 0.38%. However, the fund provides little diversification as over 85% of assets are comprised of financial and industrial companies as well as government agencies. 

Go-go growth over dividend darlings

Falling interest rates forced income-starved investors to seek yield in equities. Shares of companies like Procter & Gamble, Coca-Cola, Pepsi, Kraft, Kinder Morgan, and Altria were all bid up as investors sought stable dividend payers. But as interest rates rise, investors will choose safer bonds over riskier income stocks. 

Already we're seeing a rotation out of dividend stocks and into faster growing names. Just take a look at companies that are trading near their 52-week highs:

Mainstream adoption of organic and natural foods is driving growth at Whole Foods Market

The growing Chinese middle class is fueling earnings and dividend hikes at McDonald's and Starbucks

The boom of online commerce has generated multi-decade runs at, and eBay

These are companies leveraged to secular growth themes that won't disappear if interest rates rise 1%. Investors won't sell these stocks for a slightly higher rate on U.S. Treasuries. 

Foolish bottom line

Bonds still deserve a place in your portfolio due to the diversification and income they provide. But rising rates are a real threat and investors must reposition themselves appropriately. 

If you're on the lookout for high-yielding stocks, The Motley Fool has compiled a special free report outlining our nine top dependable dividend-paying stocks. It's called "Secure Your Future With 9 Rock-Solid Dividend Stocks." You can access your copy today at no cost! Just click here.

Robert Baillieul has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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