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Higher Interest Rates Are Coming – 5 Ways to Protect Yourself

There’s a lot of talk about interest-rate risk as the Federal Reserve looks to tighten monetary policy in the next year or so. The Fed has already drawn down some of its quantitative easing, and many investors believe that Chairwoman Janet Yellen plans to raise interest rates by next spring.

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In fact, the body of evidence so firmly favors higher interest rates and tighter Fed policy that one recent survey showed unanimous expectations that yields on the 10-year Treasury note will rise in the next six months.

This, from MarketWatch:

“Jim Bianco, of Bianco Research, points out in a market comment Tuesday that a survey of 67 economists this month shows every single one of them expects the 10-year Treasury yield to rise in the next six months.

The survey, which is done each month by Bloomberg, has been notably bearish for some time now, with nearly everyone expecting rising rates. In March, 97% expected rising rates. In February, 95% expected yields to climb. And in January, 97% held that expectation. Since the beginning of 2009, there have only been a handful of instances where less than 50% expected rates to rise.”

It has long been clear that the Federal Reserve cannot continue its path of easy money forever, and investors haven’t questioned whether tighter polities will hit … but when.

And judging by the fears of rate increases in the very near future for Treasuries, it appears Wall Street is preparing for a move higher in interest rates sooner rather than later.

If you’re in the dark about what to do with your portfolio, here are some tips on how to prepare:

Interest Rate Increases Don’t Matter If You Hold to Maturity

The biggest thing people hear is that when rates rise, the price of bonds goes down. That’s true, because newer bonds will yield a better interest rate and be in more demand while older debt with a lower yield will be less valuable on the open market.

However, if you are an income-focused investor who holds bonds to maturity, that’s not a problem you need to worry about.

After all, if you never sell the bond, it doesn’t much matter what market pricing is; if you’re content with your coupon payments, then simply keep collecting them.

Be Wary of Long-Term Bond Funds

The fact that bond principal declines as rates rise is a big problem for bond funds, however, because the vast majority of bond funds do have turnover and sell bonds regularly. That leaves investors open to principle losses.

Consider that last year, from May to early July 2013 when rates on the 10-year T-note rose about 1%, the iShares 20+ Year Treasury Bond ETF (TLT) lost about 15%. That’s because 95% of the holdings are more than 25 years in duration, and the longer the duration, the more susceptible bonds are to interest rate increases.

This is a very real example of what you can expect in long-term bond funds when interest rates rise.

Short-Term Bond Funds Are Safe, But Don’t Yield Much

If you don’t like the idea of buying individual bonds but don’t want to get burned by raising rates, short-term bond funds are an alternative. There still is a risk to a loss in principal, yes, but much less so.

As a working example, compare the deep declines in TLT to a less than 1% decline in its sister fund, the iShares 1-3 Year Treasury Bond ETF (SHY) in that same May-to-July period that saw a significant uptick in interest rates.

Just remember that the yields in shorter-term bonds are much lower, but that’s the tradeoff you’ll have to consider if you want to avoid the risk of losing principal when rates rise.

Remember Bond-Like Stocks

If you’re looking for income, you might be frustrated by this struggle between settling for either risk to bond principal or settling for meager coupon payments. As such, bond-like investments including utility stocks, blue-chip telecoms, REITs or other stable dividend payers might be a decent supplement to your income portfolio.

There obviously is risk here of course, and the loss to stocks could be much more significant than the loss to bond funds should things sour. And furthermore, since so many income-sensitive investors are shopping for dividends, many of these players have awfully high valuations.

But if you do your homework, you can find some good dividend stocks or dividend-focused stock funds that are a fair value and relatively stable right now.

Be Wary of Junk bonds

One important thing to remember as an investor is that bonds are debt, and that higher interest rates mean higher costs for borrowing.

So as interest rates tick higher, it’s natural to see some bonds or bond funds yielding 6% or 7% or even more … but remember this big potential reward comes with big risk, since the kind of companies borrowing high-yield or “junk” debt have a good chance of default.

We have been starved for higher returns on government and corporate bonds for so long that I expect many income-oriented investors so hungrily load up on junk bonds should interest rates move higher. But if those funds suffer big bond defaults, those investors may regret chasing yield.

Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. As of this writing, he did not hold a position in any of the aforementioned securities. Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP

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