How to Hedge Against Rising Interest Rates

In an economic climate where interest rates are near historic lows, when the economy begins to recover, interest rates will eventually start to rise. There are several investment strategies to partially hedge against a rise in rates.

Consider the relationship of bond prices and yields. As bond prices increase, yields decrease; thus, as interest rates go up, bond prices will decline.

Purchasing an exchange-traded fund that shorts the bond market, such as the Ultra Short Lehman 7-10 Year Treasury ETF, attempts to capitalize upon that relationship. Short bond funds attempt to inversely replicate the performance of the bond market; as bond prices fall, the prices of short bond funds should rise.

Examine the commodities market. Eric Fry on "The Daily Reckoning" website reports that "The Wall Street Journal" suggests that portfolios that add commodities after the Federal Reserve raises rates perform better over time than others.

The commodities market can also be entered through an ETF. Certain ETFs, such as the iShares Commodity Indexed Trust, attempt to mirror the performance of a basket of various commodities. Others focus on a specific commodity, such as the SPDR Gold Shares, SPDR Silver Shares or oil and gas ETFs.

Purchase a product devoted to hedging interest rates. Most large commercial banks carry a suite of hedging products, including the collar, forward rate agreements and interest rate swaps. Most of these products are relatively complex and can be costly. Expert guidance and consultation is essential.

A collar involves two interest rate options, purchasing one above the current interest rate and selling one below the current interest rate. This strategy confines interest costs to a defined band. At certain intervals, generally every six months, the market interest rate is compared with the interest rate purchased, and any difference in rates is paid.

A forward rate agreement is a hedge purchased by the investor. If interest rates rise by the time the investment is made, the forward rate agreement will profit. Although capital itself will still need to be borrowed at the higher interest rate, the profit on the forward rate agreement will lower the interest cost to the current interest rate.

An interest rate swap is an agreement between two parties to make interest payments at fixed dates. Generally, one investor will pay the other a fixed rate of interest, while the other investor makes interest payments in line with market rates. The risk of an interest rate swap is limited to an unforecast change in interest rates, as no capital is exchanged.