For the past three decades, investors have become accustomed to operating in an environment where interest rates were on a gradual decline. Granted, there have been a few years when rates have increased, but for the most part, investors were spoiled with increasing bond values as rates steadily fell.
It appears those days are behind us.
As the economy strengthens and the Federal Reserve pares back its bond-buying program, interest rates could very well rise. In fact, there's no reason why the next couple of decades couldn't be a complete reversal of what's transpired over the previous 30 years. Given that possibility, it's wise for investors to understand what impact this could have on their portfolios and to take steps to prepare for the worst.
Isaac Newton's third law of motion states that for every action, there is an equal and opposite reaction. The main problem with rising interest rates is that they coincide with declining prices of many securities—namely, fixed-income vehicles such as bonds and preferred stocks. Simply, as interest rates rise, the value of those investments falls.
(Read more: Are bonds still safe bets? It depends)
In 2013 many investors experienced firsthand what happens when rates rise: The value of the highest-rated bonds fell. Interest rates on long-term U.S. Treasurys rose throughout much of the year and resulted in declining values to the holders of the bonds. Unfortunately, some people were surprised to see their bond holdings decline in value, given the perception of "safety" these bonds have.
The great irony with bonds is that, although many investors purchase them to provide safety and stability in a portfolio, they can actually cause great damage in a rising interest-rate environment. The investments that were originally purchased to reduce risk in a portfolio can actually increase risk.
So what should investors do to protect themselves in a rising interest-rate environment? Consider these five things:
- Analyze your current holdings. If you work with an investment advisor or broker, request an analysis of your current fixed-income portfolio. If you do things on your own, find a tool online that can help you with your analysis. Determine what types of bonds you own, the duration of those bonds and their credit ratings. Also, evaluate the types of investments you own that may act like bonds, such as preferred stocks.
- Abandon bond index funds. In periods with higher interest rates, bond index funds—such as the ones that can be purchased in mutual funds, ETFs and many 401(k)s—can be scary places to invest. While index funds may be great for equities, in a rising interest-rate environment, professional management is more important than ever. If you own bond index funds, consider swapping them for actively managed ones.
- Shorten the maturity of your bonds. In general, the further out the maturity date on a bond, the greater the loss when rates rise. Many investors don't feel it's worth the risk to own long-term bonds, given where we are in this economic cycle. Take a look at the duration and average maturity of the bonds or bond funds you currently own. If your duration is more than five to seven years out, you may want to look to a bond manager who holds shorter-maturity bonds.
- Expand your horizon. Some fixed-income investors only want the highest-rated bonds in their portfolio and opt for longer maturities in search of yield. Rather than just stick with government bonds, consider adding fixed-income managers that incorporate alternative assets, such as convertible bonds, floating rates and non-agency mortgages. Many of these nontraditional fixed-income vehicles don't react in the same way as traditional bonds when rates rise.
- Reduce your exposure to bonds. Having a portfolio that is heavily weighted to bonds may not be the wisest move right now. If rates rise dramatically, your portfolio could suffer a substantial decline and could wipe out several years' worth of interest payments. Consider paring back on your bond holdings while increasing your holdings in different asset classes, such as equities, real estate, commodities and even cash.
(Read more: Expert offers tips on handling rising rates)
It's essential to evaluate the fixed-income risk within the context of your overall portfolio risk. Typically,volatility in the fixed-income realm is much less than the volatility in other risk assets—namely, equities.You may decide that taking on greater credit risk and less duration risk best suits your objectives.
Having a clear understanding of what type of risk your fixed-income exposure is subject to is important. But whatever your tolerances, fixed-income should continue to play an important role in any well-balanced portfolio.
—By Scott Hanson, Special to CNBC.com. Scott Hanson, a certified financial planner, is a senior partner at Hanson McClain Advisors in Sacramento, Calif.