4 Tips for When the Fed Hikes Rates

Talk about a slow-motion picture! For the past five years, Wall Streeters have been speculating—eagerly, but mostly in vain—that interest rates were about to rise. GET READY FOR INFLATION AND HIGHER INTEREST RATES intoned the aptly named Dr. Arthur Laffer in a June 10, 2009 Wall Street Journal op-ed piece.

Since that date, of course, the federal funds rate (the rate banks charge each other for short-term loans) has remained stuck at zero to 0.25%. The 10-year Treasury yield has bounced somewhat from its 2012 lows, but remains one-third below where it stood when Laffer penned his article.

Still, it's a pretty sure bet that at some point, the Federal Reserve will snug up its ultra-easy monetary policy—and interest rates will pop. Let's take an educated guess at when that moment might arrive, together with the likely consequences for your bonds and other interest-sensitive investments.

What the Futures Say

Some analysts try to get a handle on the likely course of Fed policy by listening to the gobbledygook spewed by Janet Yellen and other Fed spokespersons. I prefer to watch the trading in federal funds futures contracts. (You can look up current quotes at www.cmegroup.com.) While futures traders certainly aren't omniscient, the pricing of the fed funds contracts gives you a baseline: It tells you what mainstream observers are expecting. You can disagree with the consensus, of course, but you should have good reasons for doing so.

As we speak, the futures market doesn't expect the fed funds rate to climb even to a full 0.25% (from the present zero to 0.25% range) until June 2015. The consensus is anticipating a 1% rate—very modest indeed by historical standards—in April 2016, 20 months from now.

If I saw mounting evidence that the U.S. economy was about to take off into the wild blue yonder, I would challenge the futures market's view. But I'm picking up few, if any, such signals. More likely, growth will just continue to plod along.

In that case, yields on short-term money market instruments will remain extremely low for another year at least, presenting little competition for bonds of longer maturity or lower credit quality. Investors who exit their bonds (and bond substitutes, such as preferred stocks) too soon will regret it, because their income will drop sharply.

Even after the Fed gets around to nudging rates up, the impact on longer-dated bonds may be less severe than during last year's "taper tantrum." Undoubtedly, bond prices will feel some downward pressure. (As yields rise, bond prices fall.) If, however, bond traders sense that the Fed plans to stop turning the screws before short-term money rates reach, say, 2%, prices for long-dated bonds may not fall significantly below last year's lows until 2017—or later.

Walk, Don't Run

So don't rush off in a panic. Instead of undertaking an "extreme makeover" on your fixed-income portfolio, I advise you to proceed cautiously and gradually as the evidence unfolds. Specifically, here's what I suggest:

  • Peel off any remaining Treasuries you may own. As the lowest-yielding members of the bond fraternity, Treasuries have the most to lose from a rise in rates. Plan to exit your Treasuries if the benchmark 10-year yield drops to 2.3% or jumps to 2.9%, whichever occurs first.
  • Hold, but don't add to, bond funds that use borrowed money (leverage). As long as short-term borrowing rates stay at rock bottom, these funds will continue to pump out much higher yields than you could hope to earn with an ordinary, unleveraged bond fund. However, this advantage will narrow when rates begin to rise.
  • Hold, but don't add to, your preferred stocks. Our preferred stocks have put on a sparkling performance so far in 2014, with the five issues in the main model portfolio notching a total return of nearly 15% year to date. Because of their sizable yield premium over Treasuries, our preferreds will likely retain their value much better than Treasuries in a rising-rate environment. Still, preferreds typically carry no maturity date, so they're quite sensitive to rate changes. It's too late for risk-averse investors like us to buy them, but too early to sell.
  • For new money, favor funds that invest in shorter-maturity paper. These instruments will lift their payouts soonest when rates begin to rise. Reasonably safe vehicles include PowerShares Senior Loan Portfolio (NYSE: BKLN), which invests in floating-rate bank loans; and Wells Fargo Advantage High Income Fund (STHYX; 800/222-8222, $2,500 minimum), a no-load mutual fund that invests in high-yield corporate bonds with an average maturity of just four years. Current yields stand at 4.0% for BKLN and 5% for STHYX.