How To Prepare Your Portfolio For Rising Interest Rates

StreetAuthority Network

As interest rates collapsed in the past few years to multi-decade lows, investors had no choice but to flee low-yielding government bonds and bank CDs for higher-yielding, dividend-paying stocks. From master limited partnerships (MLPs) and real estate investment trusts (REITs) to foreign government bonds, it's been an era of profitable investing.

Yet signs are emerging that this trend may start to reverse course.

The yield on the 10-year Treasury note has spiked higher since the beginning of May to roughly 2.2%, and if we continue to see robust monthly employment reports, then these rates will probably climb steadily higher as the year progresses.

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Simply put, the economy is getting healthier. Even given the likelihood that the Federal Reserve will keep its benchmark interest rates quite low for a few more years, the longer-term bonds, which are influenced by economic trends, have begun to anticipate a broader upturn.

So are the MLPs, REITs and other dividend payers likely to suffer if investors start to see attractive yields in the safety of government bonds and bank CDs? Not necessarily. But you need a keen understanding of the factors behind the rate changes, as they will bring disparate effects to different types of asset classes.

Before digging deeper, understand that the yield on the 10-year Treasury is likely to rise at a slow pace, and it could be a year or more before that figure moves past the 3% mark. The only concern is that the Fed's massive pump priming (known as quantitative easing or QE) is so unprecedented that we don't know how bond prices will react when the Fed starts to wind down the program. It could lead to a bit of chaos, which the bond market hates. Still, as long as the 10-year Treasury remains below 3%, it's premature to get too alarmed about the recent rate rise.

The Cost Of Money
Putting aside for a moment the question of relative yields between bonds and stocks, you should be more concerned about which companies will be hurt or helped by rising rates. We've already seen potential losers in the group of mortgage REITs such as Two Harbors Investment (TWO) and Annaly Capital (NLY), both of which have fallen more than 10% in the past three months. These firms take advantage of low borrowing rates and garner profitable spreads by reinvesting their funds into higher-yielding mortgage-backed securities.

Traditional REITs, many of which deploy debt leverage to boost returns (or at least on properties that carry variable interest rate debt), are also falling out of favor right now. In just the past four weeks, a number of REITs have fallen more than 10%, including:

  • Cousins Properties (CUZ)
  • Duke Realty (DRE)
  • National Retail Properties (NNN)

(Besides traditional yield plays, homebuilders will also feel the pain of rising rates as pricier mortgages narrow the pool of potential homebuyers. Shares of D.R. Horton (DHI), for example, have slid 10% in the past month.)

Higher rates will be felt most heavily by companies that carry variable rate debt, though you need to research and find out whether a specific company's floating rate debt is tied to LIBOR, which is likely to stay low for a while longer, or high-interest credit lines that are more closely aligned with 10-year bond rates. Rising variable interest rates will start to lead to lower earnings for highly leveraged companies.

The Winners
Conversely, any companies that have suffered from low returns on their cash are bound to benefit. Charles Schwab (SCHW) for example, has made few profits on its money market funds or on the cash balances it holds for clients. Rising rates would help boost Schwab's core earnings power.

In a similar vein, insurance companies will also soon start earning more money on their hefty cash balances. I looked at this group a few weeks ago and noted that what had been a big headwind, pushing their shares below book value, could soon become a tailwind.

Risks to Consider: The yield on the 10-year Treasury has spiked higher in a short time on several occasions in the past, so you may want to see yields pushing above 2.5% -- a level not seen in nearly two years -- before making major portfolio moves. Still, this is a good time to think about the steps you'll take in such a transition.

Action to Take --> The long bull market in bonds that began in the early 1980s appears to be winding down. Although dividend-paying stocks of all stripes have benefited, it's time to separate the field into winners and losers by looking at how interest rates affect each of these investments' earnings. Any firm that uses very low interest rates to juice profits has probably seen a peak in profits, and smaller dividends may be looming ahead.

Add in the fact that rising fixed-income rates lessen the appeal of riskier stocks, and a tide may be turning. Still, it will be quite some time before fixed income investments offer the 4% or 5% yields that many crave.

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