Interest rates have slowly climbed from their recent historic lows, and they’re likely to keep on climbing for some time. As interest rates go up, many common types of investments will suffer — but others will rally. Here are some assets that do particularly well when interest rates rise.
Treasury Inflation Protected Securities (TIPS)
The interest rate on a TIPS bond doesn’t change if rates rise, but the principal increases with inflation (and inflation nearly always goes hand-in-hand with rising interest rates).
So while you’ll still be getting the same interest rate payout on your TIPS, that payment will be based on the new, higher principal. And once the TIPS bond matures, you’ll get back your principal at the increased level thanks to the inflation adjustments.
On the other hand, if you guess wrong and run into a period of deflation, the principal on your TIPS will shrink instead of growing. The good news is that once your TIPS bond matures, if the bond’s principal at that point is lower than your original principal, you’ll still get your entire initial investment back.
Short-term bond funds
Because short-term bond funds are constantly buying new bonds to replace the ones that have just matured, they can take advantage of the rising interest rates that crush the value of long-term bond funds.
If you’re a hands-on investor, you can eschew bond funds in favor of picking out your own short-term bonds or CDs. For these purposes, it’s best to stick with investments that will mature in 90 days or less. You can even build a short-term bond ladder using 90-day securities, buying new ones every month to replace the old ones as they mature.
Most stocks tend to falter when interest rates climb, but financial stocks are often a big exception to this rule. Financial companies tend to be lenders, rather than borrowers, so they profit from rising interest rates because they can charge higher rates on their loans. Look for a mutual fund or ETF that specializes in the financial sector to keep your investment diversified across several different institutions.
Where to get the money
Now that you have a list of good investments, you just need to figure out where you’re going to get the money to put into said investments. One clever option is to sell some of your long-term bonds or any other investments that have turned a loss thanks to the interest rate changes. It may sound crazy to deliberately sell at a loss, but if you use that loss to balance out your capital gains for the year, you can end up with a significant tax savings.
And once interest rates begin to decline again, you can repurchase those long-term bond investments (as long as you wait at least 30 days to satisfy the IRS). You should never sell an investment just to save on taxes, but if you need to get rid of one investment in order to finance another, tax considerations can play a part in your decision.
Similarly, picking an investment solely because it performs well under certain interest rate conditions is unwise. Any investment should be chosen based on your overall investing strategy and existing portfolio. If the investment passes those tests, then by all means factor in its viability in a rising-rate environment before making your final decision.
— Wendy Connick
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Source: The Motley Fool