(07/10/13) Higher Rates? Prepare Your Portfolio

There has been a remarkable change in the bond markets in the past couple of weeks, with yields spiking dramatically higher. Here are steps to help prepare your portfolio, says Gordon Pape of Internet Wealth Builder.

As bond yields rise, market prices drop. This phenomenon puzzles some investors, so let me take a moment to explain why this happens.

Let's say you own a ten-year bond that is trading at par ($100) and yields 2%. That means you collect $20 a year for every $1,000 of face value.

Now assume that interest rates shoot up and new issues come out at 2.5%. No one is going to be willing to pay $100 for your 2% bond when they can get a yield of 2.5% at the same price.

If you want to sell your bond, you will have to reduce the price in order to find a buyer. In this case, for your bond to yield 2.5%, the price would have to drop to $80.

The buyer would then collect $20 a year for an investment of $800, for a 2.5% yield. Meantime, you've lost 20% of your capital. That's how dramatic even a modest hike in interest rates can be.

This explains why bond prices have weakened significantly recently, hitting bond funds and ETFs in the process. But other types of interest-sensitive securities, such as REITs, fixed-rate preferred shares, and defensive dividend stocks, have also been affected.

We have known for some time this day would eventually come. Interest rates have been artificially low since the credit crunch of 2008-so long that we've come to take them for granted.

But if the message the bond market is sending is accurate, those days are over. If the economy continues to gain momentum-still a big assumption at this point-what we've seen in the past few weeks is only a preview of what's to come.

This means that some investors need to make changes to their portfolios. Securities that performed well through the long period of low interest rates and a weak economy will no longer generate acceptable returns, and in many cases will actually lose ground.

This will happen over time, so there is no need to panic. But the time to start adjusting for a new investment era is now.

The first step is to review your fixed-income holdings, particularly bonds, bond funds, and preferred shares. A portion of your portfolio should always be dedicated to this class of asset; however, you need to limit the risk inherent in a rising interest rate environment. Here are some ways to achieve this.

First, reduce your overall fixed-income weighting. Move some of the money into cash or cash-equivalent securities. If you are light on the equities side, you may wish to add to those positions as well.

As far as bonds and bond funds are concerned, stay short-term. Don't hold any fixed-income securities with a maturity of longer than five years unless you intend to keep them for the full term.

The longer the term to maturity, the more vulnerable a bond will be to interest rate hikes. This does not mean that short-term bonds and funds are immune from loss, but the impact will be minimal compared to that on a 20-year bond.

For evidence, take a look at the recent returns on various types of bond funds. They have all been hit, with high-yield funds as a group taking the worst beating. Most short-term bond funds have lost ground, but in almost all cases the decline has been less than 1%.

If you want to move some of your fixed-income assets into cash, your best choice right now is a high-interest savings account.

Money market funds are still returning next to nothing, despite the interest rate hikes, because their fees eat up the profits. If you deal with a brokerage firm, ask what high-interest account they recommend and find out the current rate. It should be upwards of 1%.

For preferred shares, focus on floating-rate issues. The dividends will be gradually adjusted upwards as rates rise, thus minimizing the impact on the market price. Reset preferreds that are coming due within a year or two are also a possibility, but take a close look at the reset terms before deciding.

Do not make the mistake of liquidating all your fixed-income assets for fear of loss. The end of the bond bull market has appeared to be imminent several times in the past few years, and each time events have conspired to keep it going. Moreover, fixed-income investments provide a cushion for your portfolio in the event of a stock-market plunge.

Your goal at this stage is simply to minimize risk and preserve capital. Your fixed-income securities aren't going to generate anywhere near the level of return that we've enjoyed for the past five years for some time. But their day will come around again. Plan accordingly.