The ongoing tapering initiative of the U.S. will continue, pundits say. To that point, many financial experts believe we can expect a rising interest-rate environment in the near future.
As interest rates rise, bond prices will decline. This means bonds and exchange-traded funds (ETFs) with higher average maturities and durations are more susceptible to interest-rate risk caused by inflation.
With historically low interest rates, fixed-income investors continue to be concerned about rising rates and the effect on their portfolios. However, rising rates do not necessarily mean negative total returns. While rising rates adversely impact bond prices, various asset classes respond differently, and active portfolio management can help mitigate the impact on total returns.
I took some time to talk with certified financial planner Barry Glassman, who detailed what investors should do to prepare for a rising interest-rate environment. Glassman is founder and president of Glassman Wealth Services, McLean, Va.
Q: Where should investors look to invest in a market where interest rates are rising?
Glassman: Generally, the worst place to be when rates are rising is in bond funds or bonds with long maturities [duration] and low coupons. These bonds are most susceptible to price declines, as the principal won't be repaid for a long time and the low coupon does little to offset the rise in rates.
Bonds with higher coupons and shorter duration are better insulated from price declines. An investment that falls in this category are high-yield corporate bonds [junk bonds]. These are bonds issued by corporations that are below investment grade and have had to offer higher coupons to attract capital. The higher coupon and generally shorter maturities [most are less than 10 years' maturity] mean less price sensitivity to rates.
(Read more: Buckling up for a bond-rate bump)
As long as the economy is solid and these companies are doing well, bond prices tend to be less impacted by rising rates than investment-grade corporate bonds. And the higher-coupon [yield] helps to offset price declines.
Floating-rate bonds, also, are investments that are better insulated from price declines and are issued by corporations below investment grade. The difference being, these bonds pay a floating rate of interest that typically adjusts monthly or quarterly.
There are two advantages to these investments. First, when shorter-term rates rise, the interest payments made by these bonds increase when they hit the reset period [monthly, quarterly]. Second, the price sensitivity of these bonds is much lower because of this periodic interest-rate reset. The pricing of these bonds tends to be much more stable during rising rate environments.
Q: Let's talk more about bond investing in a rising interest-rate environment. Do you believe bonds can play a crucial diversification role in a portfolio, even in the event of a significant downturn?
Glassman: Yes, I do. Bonds can and should play two roles in clients' portfolios. The primary role for bonds has historically been to produce safe income for cash-flow needs. This is certainly harder to accomplish today with government bonds, investment-grade bonds or municipal bonds because absolute yields are so low.
(Read more: Bonds are still a good bet)
The secondary role for bonds within a diversified portfolio is to provide ballast and to insulate the portfolio from losses during economic recessions and equity bear markets. Typically, the Federal Reserve lowers interest rates during recessions, extended market corrections and the periodic bear market.
As market interest rates decline in response, quality bonds and bond funds rise in price in response to these lower interest rates. The positive performance of a quality bond portfolio in times of stress helps to balance the decline in risk assets such as stocks. We have seen this happen time and time again during the Asian contagion in 1997, the 2000–2002 bear market or the 2008 bear market.
The key is knowing what kind and type of bonds to hold and in what mix [government bonds, muni bonds, investment-grade, high-yield corporates, floating-rate, etc.] and when to rebalance those holdings.
Q: Are clients concerned about a bond bear market?
Glassman: They are concerned, primarily because the media and financial press have been giving this topic so much attention. At Glassman Wealth Services, we have been focused on this risk now for a couple of years and have migrated our portfolios away from longer-maturity, lower-yielding securities [investment grade] and into higher-yielding, high-quality noninvestment-grade corporate bonds and loans. In addition, we have been using long/short credit [bond] funds as another way to offset some of the inherent and potential risks to price declines when rates eventually rise in a sustained manner.
(Read more: Investors eye alternative investments)
Q: Do you feel investors should be concerned about a bond bear market?
Glassman: Yes, but not for the reasons you might think. A rising rate environment is not a bad thing. As long as it doesn't happen in an abrupt, uncontrolled manner, it's actually a good thing. Why? Because rising interest rates allow investors who need income to reinvest principal that comes due from their bonds at higher rates.
Personally, I think more is being made of the individual risks in a bond bear market.
What I am truly most concerned about is not rising rates, but about the potential behavior by bond investors. So much money has flowed into "bonds funds" that if/when this money tries to move out en masse, it could cause a disruption in the liquidity and pricing for bond funds of all types.
Q: What should investors do to prepare for this?
Glassman: The most conservative thing one can do is to shorten the maturities of the bond funds or individual bonds they own. This ensures that if/when rates rise, their bonds will not likely have lost much in price decline, and this capital can be reinvested periodically into a higher-rate environment.
We suggest maintaining a balanced portfolio of shorter-duration exposures [for immediate cash-flow needs] married to higher-yielding, higher-quality noninvestment-grade corporate bonds and loan funds.
(Read more: Don't bail on bonds)
Q: What impact does all of this have on stocks and bonds?
Glassman: In a rising rate environment, bonds with the lowest coupons and longest maturities will most certainly decline in value. However, if rates are rising for the right reasons—stronger economy, more jobs, greater demand for loans/credit—then high-yield bonds should hold up well, and floating-rate bonds [bank debt] should do well, too.
Again, if the economy is improving—and along with that improvement comes increased revenues and profits—then stocks don't necessarily have to decline as rates rise. In fact, there have been many periods during which stocks have increased when interest rates rose.
Q: Investors looking to manage fixed-income portfolios may be worried about generating income in a low interest-rate environment. Do you have any advice for them?
Glassman: Don't overreach for yield in today's environment. Stay shorter duration, higher quality for immediate [12 to 18 months] cash-flow needs. Balance the rest of the bond portfolio thoughtfully with a combination of high-quality corporate high-yield floating-rate bonds and perhaps, as appropriate, long/short credit funds.
Also consider creating a ladder of individual bonds. A bond ladder is a structure where you own individual bonds with, as an example, 25 percent of the bonds that mature in one year, 25 percent that mature in two years, 25 percent that mature in three years and 25 percent that mature in four years.
The idea is that in each year, as 25 percent of the bond ladder matures, this amount is reinvested in a new four-year bond. If rates have increased, the yield on that "new" four-year bond is likely to be much higher than the four-year bond that was purchased just one year ago.
The benefit of a ladder is it brings balance and discipline to a bond portfolio and it does not require one to time the interest-rate environment. As long as rates increase over time, a bond ladder ensures there is regularly available capital to reinvest at higher rates.
(Read more: Is China's love for Treasurys waning?)
Q: What are the top three tips you discuss with clients to deal with a rising interest-rate environment?
Glassman: Have enough cash and/or very short-duration bonds available to meet spending needs for the next 12 to 28 months.
Invest in credit instead of longer maturity. In other words, thoughtfully invest in higher-yielding, strong corporate credits where the yield compensates for the company risk. Don't simply buy longer-dated government bonds or investment-grade bonds in the search for yield. Longer-maturity [duration] securities will lose the greatest percentage if rates rise.
Diversify your investments. Consider shorter-duration, high- yielding bonds; higher-quality noninvestment-grade [junk] bonds; floating-rate bonds [bank debt]; and long/short credit funds.
—By Jim Pavia, CNBC.com. Follow Jim on Twitter @jimpavia.