Governments often raise interest rates in an attempt to slow down inflation. Rising interest rates can create problems for bondholders because newly issued high-yield bonds drive down the market value of older, low-yield bonds. Consequently, bondholders often try to move out of bonds before rates rise. While no one can accurately predict the future, if interest rate rises seem inevitable there are several investment strategies that you can consider.
When you buy a bond, the bond issuer promises to return your premium at the end of the bond term. But if you sell your bond mid-term, you may not get face value for it if other bonds with higher interest rates are readily available. However, the face value of your bond has no impact on the income payments that you receive from the bond issuer. If you feel more comfortable with bonds than other kinds of investments, you can invest in short-term income generating bonds because these bonds experience less price fluctuation than long-term bonds. In addition, interest rate increases often only impact bond prices in one nation or region, so international bonds may provide you with some protection in a rising rate environment.
Governments can raise interest rates to stop a booming economy from growing too fast. But interest rate increases are also necessary when credit agencies downgrade a nation's credit rating. This often occurs during severe recessions, and credit rating cuts are symptomatic of economic problems that can impact all types of investments. During tough economic times, you may consider parking your money in short-term certificates of deposit that are protected by the Federal Deposit Insurance Corp., or FDIC. In doing so, you protect your principal but keep your funds fairly liquid so you can take advantage or rising rates if and when those rates materialize. The trade-off is that in the short-term you limit your potential returns.
Fixed-income instruments such as CDs and bonds expose investors to inflation risk. During inflationary periods, the yields paid on fixed instruments sometimes fail to keep pace with inflation. You do not lose any money when this occurs but in real terms you do lose spending power. Historically, stocks have outperformed other types of securities over periods of 10 years or more. While much more volatile than income-generating securities, stocks -- especially stocks in large, stable companies -- may enable you to evade the ravages of inflation.
Treasury Inflation-Protected Securities
The federal government issues short-term debt instruments known as Treasury Inflation-Protected Securities. TIPS have a duration of up to 30 years and, unlike some types of government bonds such as savings bonds, you can sell TIPS to other investors prior to maturity. When the consumer price index rises due to inflation, TIPS rise in value and the opposite occurs when the Consumer Price Index (CPI) dips. TIPS track the CPI and many investors therefore buy TIPS when inflationary forces begin to affect the economy. In the long-term, other types of securities offer higher yields but TIPS provide short-term safety for your money.
If interest rates rise, the most negatively affected investors are the people holding long-term, low-yield bonds. People who invest in TIPS, stocks, CDs and other types of bonds may fare better than people who invest in long-term bonds. But there are no guarantees. Many people address inflationary fears by investing in a wide variety of different types of instruments. Even bondholders can diversify by buying bond funds rather than individual bonds. However, regardless of interest rates, you should not take undue risks with money that you need in the short-term. Therefore, consider your needs, your risk tolerance and the economic indicators before radically altering your investment portfolio.
- Fidelity.com; Get Ahead of Rising Rates - Before They Get Ahead of You; Roger Fillion; January 2010
- Vanguard: Bond Investing in a Rising Rate Environment
- Money Watch; Wells Fargo on What to Do with Rising Interest Rates; Allen Roth; June 2011
- Bankrate.com; The Pros and Cons of Rising Rate CDs; Constance Gustke; March 2011
- Treasury Direct: TIPS In Depth