Interest Rates are Rising...Here's Your Next Move!

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

No one, and I mean no one, has the ability to consume Wall Street quite like Ben Bernanke. After an upbeat U.S. jobs report, interest in the bearded Fed Chairman has reached a fever pitch.

Now, more than ever, Wall Street is telling us that they're sure the end of "QE-infinity" is coming soon. Some experts are even saying that Benanke's Fed may taper its bond buying program by summer's end.

Here are a few investments that will be affected by rate increases, and what you should do next.
 
Treasuries: the worst investment in the market today
 
It's no surprise that a rise in interest rates will obliterate prices on existing bonds. If you're new to bond investing, put simply, bond prices and interest rates move in opposite directions. This is actually really simple to understand if you follow this simple example; if you owned a bond with a 4% yield it would become less valuable when other, similar, bonds issue 5%.
 
Simple right? It all makes sense. What doesn't make sense is why high yield (junk) bond funds have been hit harder than treasuries. For instance, Pimco High Income Fund (NYSE: PHK) has been obliterated as Bernanke has warned against the dangers of "yield-chasing" investors, does this make any sense? At the same time iShares Barclays U.S. Treasury Bond fund (NYSEMKT: GOVT) has only dropped $1 per share. 
 
Quite baffling, indeed.
 
When you take into account that the GOVT treasury fund's yield of 1.05% also gets expenses of 0.15% taken out, you only have an absolute return of 0.9%. Is that really worth it? I'd rather chase the yield of a PHK, at least you know that when the shares drop you have some yield to keep you whole.
 
As crazy as it may sound, I honestly feel that if you are going to be in bond, a junk bond fund could be the way to go. The high yields make up for price risks due to interest rate decreases, and the wide diversification guards against the essential risky nature of junk bonds, and defaults.
 
MBS REIT's: dangerous ground
 
What can you say about Chimera (NYSE: CIM) and Annaly Capital Management (NYSE: NLY). No, I mean it, does anyone really, really understand these businesses?
 
I won't claim to know these shadowy REIT's better than you, but I do know a few things about each.
 
1. Annaly and Chimera are not traditional REIT's. Both companies are from the same management tree and they specialize in mortgages, not properties. These investment trusts do not originate mortgages however, rather they invest in and manage agency mortgage-backed securities.
 
2. Both of these investments have returned a remarkable amount of cash to their investors and management deserves a tremendous amount of praise for that. Even today, Annaly pays a whopping annual dividend yield over 13% and Chimera pays out 12%. That's a bit of a mirage, however, as the dividends have been shrinking in recent quarters.
 
3. Both Chimera and Annaly have struggled with rising interest rates and will continue to do so.
 
In recent years Chimera and Annaly's management teams have pulled the ultimate Houdini act, they've raised capital and turned it into more capital for shareholders. While they deserve some praise for the past, the future is much more questionable.
 
The reason things look shaky now is that, as interest rates rise, the cost of the capital they raise will go up as will the number of pre-payments. When Annaly's costs get higher, and the interest on their investments stays neutral, bad things can happen. This will likely crimp margins, and dividends, significantly and it's the primary reason that both Citi and Sterne Agee cut price targets on Annaly recently.
 
Now, considering how far shares of both Annaly and Chimera have fallen already, at some point the prices should bottom. But that bottom won't come until rates stabilize, I feel you'd be best served to wait and see how what happens with rates before investing in these names.
 
A better, simpler, way forward
 
The most obvious winner, in a higher interest rate climate, should be dividend stocks. Recently, I've come to believe that well diversified dividend funds are the best place for your money today.
 
This idea is based on some simple logic.
 
1. There is always a "tug of war" for your investment dollars taking place between stocks and bonds. As interest rates rise, dividend paying stocks will need to increase pay-outs to stay competitive. Considering how flush most balance sheets are with "hoarder-like" cash piles, this is very likely.
 
2. With the market at all-time highs, the chances of a sell off are increasing by the day. So why not get yourself in a well diversified fund? You can take advantage of stock market gains, without worrying about a potential correction.
 
A top fund, I'd recommend for this approach is the Vanguard High Dividend Yield ETF (NYSEMKT: VYM). Like most Vanguard funds expenses are low, just 0.10%, but your dividend yield will be nearly 3%. The fund has a perfect five star rating by fund rater Morningstar. It's currently trading near a 52-week high approaching $60 per share, up about $12 per share this year.
 
So on top of a nice yield, the fund's price has increased with the broader market this year. The difference with a fund like this and an individual stock however, is that the downside is limited because of diversification. This fund owns shares of great stocks like ExxonMobil, AT&T, General Electric, and Wells Fargo, but it doesn't hold more than 6% of its assets in any single stock.
 
There is tremendous value in that type of safety.
 
High interest rates? Dividends rule
 
While I like diversified junk bond funds over other bond investments, today's market really calls for stocks over all bond types. The reason is very simple. When interest rates rise, bond values fall; yet when dividend stocks increase pay-outs, their values rise.
 
Since both interest rates and dividends are likely to increase, the choice is simple and obvious. Sell your bond investments, avoid REITs that rely on low interest rates for profits, and invest in dividends.
 
The safest choice truly is the best choice.
 
 


Adem Tahiri 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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