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3 moves to make with interest rates on the rise

Here are three ways to help protect your returns in a volatile climate.

  • By Daren Fonda,
  • Fidelity Interactive Content Services
  • – 06/20/2013
  • Investing Strategies
  • Investing in Bonds
  • Investing in Stocks
  • Market Volatility
  • Bonds
  • Stocks
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Say goodbye to easy money and hello to higher interest rates.

That may be the new normal if the Federal Reserve follows through on remarks by Chairman Ben Bernanke this week signaling it could end its bond-buying program in 2014.

If the program draws to a close then, it will end an era of unprecedented stimulus from the central bank -- in response to the Great Recession of 2008 -- that has pumped trillions of dollars into financial markets over the past four years.

What does the end of low rates mean for investors? Here are some answers from financial advisers and other experts we interviewed.

Q: Stocks and bonds plunged after the Fed's announcement. Does this mean we're heading for a bear market?

A: Near-term, it may take some time for things to settle. Global markets took a tumble and volatility could stay high as investors gird for a new era of higher rates and less financial support from the Fed. "Change is never easy," economist David Rosenberg at investment firm Gluskin Sheff wrote in a note to clients, "but the adjustment is underway nonetheless."

The good news: The Fed seems to be easing off the gas pedal because the economy is finally gaining speed on its own. The central bank now sees the unemployment rate falling to 6.8% or lower by the end of next year, and it raised its growth forecast for the U.S. economy to a range of 3%-3.5% for 2014, from 2.9%-3.4% earlier.

Moreover, as Bernanke noted at his press conference Wednesday, the Fed left the door open to more stimulus if the economy weakens. "The bottom line is that the Fed is keeping an open mind towards QE,"Rosenberg wrote, referring to the Fed's quantitative-easing program of buying government-backed bonds, which pumps money into the economy and the markets.

Indeed, a stronger economy could help lift corporate profits and stock prices. Historically, when the Fed has raised rates, the stock market has been higher 12 to 18 months later, notes Richard Gotterer, a financial planner with Wescott Financial Advisory Group in Coral Gables, Fla.

"While the markets may have some short-term uncertainty, longer term they remain very attractive," he says. "What investors need to focus on is that this is a positive event for the markets."

Takeaway No. 1: Don't sell in a panic. Instead, consider rebalancing and focusing on your long-term plan.

For a look at some stocks and ETFs that could fare well in this climate, see 7 stocks and ETFs for rising rates.

Q: With rates moving higher, should I abandon bonds?

A: Rising interest rates pressure bond prices since investors sell bonds with lower rates and buy new bonds with higher interest rates instead.

Long-term U.S. government bonds are especially vulnerable since they trade entirely on rate moves. So far this year, long-term Treasury bonds have tumbled 7.5%. The broader bond market, which includes corporate debt, has lost around 2%, according to the Barclays U.S. Aggregate Bond Index.

Yet while the losses may be painful, most advisers say it's important to keep some money invested in a diverse mix of bonds: whether it's 20% for young investors with a long time horizon, or 35% or more for retirees who need more stability and to preserve capital.

Bonds can still help dampen sharp swings in stock prices, says Barry Korb, an adviser with Lighthouse Financial Planning in Potomac, Md. Plus, there are ways to play defense in a rising rate climate.

One strategy is to stick with short-term, high-quality bonds, he says. You won't earn much income in these bonds, but they're less sensitive to rising rates.

Another tip he suggests: Hold a mix of U.S. government, corporate and currency-hedged foreign bonds. While these types of bonds have fallen with the rest of the market recently, in normal conditions, they don't move as closely in tandem, providing some diversification benefits. Foreign bond funds may also have higher yields than U.S. funds, particularly if they hold some emerging-market debt.

"The purpose of bonds is to help you stay the course if the market drops," Korb says. "You want some returns in bonds, but you can get more returns for each unit of risk with stocks."

Takeaway No. 2: Don't rush to sell your bonds, but make sure you check your bond mix.

Q: How can I protect my returns in this environment?

A: For starters, know what you own. Bond funds with a high average duration, a measure of interest rate sensitivity, can be deadly in a rising rate climate. If a fund's average duration is higher than its yield, it's likely to post losses if rates climb sharply. You can check a fund's duration on sites such as Morningstar.com and Fidelity.com.

Dividend-paying stocks have been especially weak, particularly higher-yielding REITs and utilities. Some of the declines may reflect profit-taking after a steep run. But if rates keep climbing, these stocks will likely trail the market even more, says Carroll Hayes, an independent financial planner near Boston who has sold these stocks for his clients.

For total returns, financial and technology stocks look more compelling, Hayes says. Higher rates should also help profit margins at banks and other lenders, he adds. Most tech companies don't pay a dividend, making them less sensitive to rates. And with strong new products they should continue to grow profits.

Stocks he owns for his clients include Nike (NKE), Starbucks (SBUX), 3-D printing company Stratasys (SSYS) and pharmacy-benefits manager Express Scripts (ESRX). Keep in in mind that these stocks can be volatile. You should do your own research or consult an adviser before investing.

Also, remember that if you're investing for dividend income, declines in stock prices boost your yield. Companies may cut their dividends if their business weakens. But S&P 500 (.SPX) company profits are still growing, albeit modestly: Wall Street analysts expect second-quarter earnings to grow 3.4%, according to Thomson Reuters.

"Your yield is your yield when you bought the stock," says Carl Friedrich, chief investment officer of Piermont Wealth Management in Woodbury, N.Y. Holding on for the long term is key — less than 15 years and you should be prepared for potential losses, he says. And if the business still looks strong, he adds, a dip in the stock price may be a good opportunity to buy more shares.

Takeaway No. 3: Keep an eye on dividend income and focus on total returns.


Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.

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