After October’s better-than-expected employment report, a December Federal Reserve (Fed) liftoff is looking more likely than it was earlier this fall. In response, U.S. interest rates have been on the rise in recent weeks, with Treasury yields reaching their highest levels since July earlier this month, according to Bloomberg data as of November 13. Remember that bond prices fall as yields rise.
While the long-term rise in rates is likely to be contained due to numerous factors, I expect rates will continue drifting higher even if the Fed doesn’t hike its Fed Funds rate next month. The central bank has made it clear that its first rate hiking cycle in nearly a decade is coming sometime soon, whether that’s December or next year.
So, it may be a good idea to start preparing your portfolio for the upcoming rate regime change, one where rates are expected to moderately increase and remain below historical averages. While there’s no such thing as a fully rate-proof portfolio, there are some simple moves you can make now to help better insulate your investments from rising rates. Here are a few ideas to consider:
- Focus on U.S. stock market sectors that appear well-positioned for a rising rate cycle. Two sectors worth considering: U.S. technology and U.S. financials (excluding rate-sensitive REITS). First, they’re cyclical sectors, which tend to outperform when the economy is strong, as is typical in a rising rate environment.
In addition, technology companies may be poised to outperform other sectors amid higher rates, in large part due to their large cash reserves and strong balance sheets. With limited debt financing, they may be less vulnerable than debt-laden firms due to the higher borrowing costs that result when rates rise. As such, this sector has the potential for sustainable growth and continued shareholder friendly policies even as rates increase.
Meanwhile, for some financial institutions, such as banks, higher rates could mean higher profits. In a rising rate environment, banks can potentially improve their net interest margins, as the difference between what they make from lending (their revenue) and what they pay for deposits (their costs) may increase. It’s no surprise, then, that according to Bloomberg data as of November 13, the performance of U.S. bank stocks has closely tracked the two-year U.S. Treasury yield, a proxy for investors’ expectations of short-term interest rates. Currently, as the data show, both measures are trending higher.
You can read more about the case for these two sectors in my recent post, “2 Sectors to Exposure When Rates Rise.”
- Consider new sources of income. One such income source to consider: exposure to companies that have the potential to sustainably grow and increase dividends over time. So-called “dividend growers1 look more reasonably priced than their high-dividend paying counterparts, according to Bloomberg data, and thus, could potentially outperform high dividend stocks in a rising-rate environment. A dividend growth strategy may also offer more exposure to cyclical sectors that have the potential to grow alongside the economy.
- Seek a better balance of risk and return. In other words, when it comes to preparing your bond portfolio for rising rates, consider reducing interest rate exposure while focusing on credit exposure. Shortening the duration of your bond portfolio can potentially help manage losses due to rising interest rates; low duration can potentially mean less volatility or price risk.
At the same time, corporate bonds typically provide the potential for additional yield over Treasuries, so exposure to this asset class can be a way to generate income to help offset some of the impact of rising Treasury yields. For more on these two fixed income strategies, check out my recent post on “Ideas for Your Bond Portfolio When Rates Rise.”