How to Protect Against Rising Rates

A trader works on the floor of the New York Stock Exchange during the afternoon of December 18, 2014 in New York City. The stock market had its best day of 2014, with the Dow Jones Industrial Average rising over 400 points after the Federal Reserve signaled that it would not raise interest rates
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Rising rates are bad news for bond investors due to the inverse relationship between prices and yields. When rates go up, prices go down—and in some cases, the move can be severe. As a result, traders who invest in fixed-income assets often try to protect against rising rates by building diversity into their portfolios with asset classes that can perform well even when rates are on the up.

Bond Interest Rate Sensitivity

The chart below displays the ways in which a 1% interest rate increase can affect bond prices.

What Causes Rising Interest Rates?

First, there are many factors that affect interest rates, and many reasons why they might rise. Here are some of the most common cases that can lead to higher rates:

  • Stronger economic growth
  • Rising inflation
  • Growing notions that the Federal Reserve will raise short-term rates at some point in the future
  • Higher risk appetites, which prompt traders to sell lower risk, fixed-income investments (which drives rates up, and prices down) and buy higher-risk bonds (which drives rates down and prices up).

Which Types of Bonds Can Protect Against Rising Rates?

With that in mind, here are six other types of bonds to think about when you're looking to protect against rising rates fueled by any of the reasons listed above.

Floating-Rate Bonds

Unlike a basic bond, which pays a fixed rate of interest, a floating-rate bond has a variable rate that resets periodically. The advantage of floating-rate bonds, compared to standard bonds, is that any risk due to changing rates is in large part removed. While an owner of a fixed-rate bond can suffer if the current interest rates rise, floating-rate notes can pay higher yields if existing rates go up. As a result, they tend to perform better than standard bonds when rates are rising.

Short-Term Bonds

Short-term bonds don’t offer the same yields as bonds with longer terms, but they are safer when rates start going up. This does not mean that short-term issues feel no effect from rising rates, but the impact is much more muted than it is with longer term bonds.

There are two reasons for this: 1) the amount of time to mature is short enough that the odds of a major increase in rates during the life of the bond are lower, and 2) bonds with shorter terms have a lower duration, and are less sensitive to rate changes than longer term debt.

Shifting your holdings to short-term debt can help reduce the impact that rising rates can have on your full portfolio.

High-Yield Bonds

High-yield bonds are on the riskier end of the fixed income spectrum, so you might not expect them to perform better than others when rates are on the up. But, the main risk with high yield is not from rate changes, rather from credit risk. This is the chance that the issuer may default. High-yield bonds, as a group, can in fact hold up well when rates are rising because they tend to have a lower duration (again, less sensitivity to rate changes) than other types of bonds that mature in nearly the same amount of time. Also, their yields are often high enough that a change in existing rates doesn’t take as large of a bite out of their yield advantage over Treasuries as it would to a bond with a lower yield.

Since credit risk is the main driver of how well a high yield bond performs, the asset class tends to do well when the market improves. This isn’t true for all areas of the bond market since stronger growth often goes hand in hand with higher rates. As a result, a market of faster growth can help high yield bonds, even as it hurts other parts of the market more vulnerable to rate changes.

Emerging Market Bonds

Like high-yield bonds, emerging market issues are more sensitive to credit risk than they are to rate changes. Here, traders tend to look more at the underlying fiscal strength of the country that issues a bond than they do at the current level of rates. As a result, improving global growth can—but not always—be good for emerging or newer markets' debt. This is true even though it often leads to higher rates in the older markets.

Convertible Bonds

If you own convertible bonds, which are issued by corporations, you know that you have the power to convert them to shares of stock. One side effect of this perk is that it makes them more sensitive to shifts in the stock market than a standard basic bond would be. In other words, there is a greater chance that convertible bonds can rise in prices when the bond market as a whole is under pressure from rising rates.

In a 2010 article, the Wall Street Journal pointed out how the Merrill Lynch Convertible-Bond Index displays how this type of bond can go against the grain. It rose 18.1% from May 2003 through May 2004 even though Treasuries lost about 0.5%. It rose 40.5% from late 1998 through early 2000 even as Treasuries lost nearly 2%.

Inverse Bond Funds

As you invest, don't forget to access the wide range of tools that can be used to bet against the bond market. ETFs and exchange traded notes (ETNs), for example, move in opposition to the underlying security. In other words, the value of an inverse bond ETF rises when the bond market falls, and vice versa. You also have the option to invest in double-inverse and even triple-inverse bond ETFs. The purpose here is to provide daily moves that are two or three times the changes of their underlying index.

There is a wide range of options that allow you to cash in on downturns in U.S. Treasury bonds. These "inverse" products come at varied maturities, as well as in many segments of the market.

While these exchange-traded products provide options for highly savvy traders, most fixed-income investors need to be careful with inverse products. Losses can mount quickly, and they don’t track their underlying indices well over long spans of time. Further, an incorrect bet can offset gains in the rest of your fixed-income portfolio, which can defeat your main goals in the long term. So be aware that these exist, but be sure you know what you’re getting into before you invest.

What Assets Should You Avoid If Rates Rise?

The assets that perform worst when rates are on the rise tend to be longer-term bonds. Treasuries, corporate bonds, and municipal bonds fall into this group. "Bond substitutes" such as stocks that pay dividends, can also suffer massive losses in a market where rates are on the rise.

The Bottom Line

Timing any market is tricky, and for most people, it's even harder to predict whether interest rates will rise or fall. As a result, as you invest, use the options above as methods for getting the most out of your portfolio diversification. Over time, a well-diversified portfolio can help you raise your odds of outperforming across the full range of interest rate scenarios.