Points to ponder when Fed raises interest rates

With the Federal Reserve looking more like it will begin a path of normalizing central bank interest-rate policy, there's greater likelihood that interest rates—and the markets in general—are in for a period of increased volatility.

So how should individual investors prepare for a rising rate environment? Here are a few things for you to consider:

Janet Yellen speaking on March 18, 2015.
Joshua Roberts | Reuters
Janet Yellen speaking on March 18, 2015.

1. Evaluate your bond holdings. Those "safe" investment-grade bond funds and bond exchange-traded funds are likely more dangerous than you may think.

Why? There is potential for a big drop in the prices of these bonds due to their sensitivity to rising interest rates, and it's greater than it's been in years. A 1 percent move up in interest rates could cost you 5 percent in your bond fund.

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The problem is that the paltry 2 percent or so yield in these bond portfolios is about as low as it's ever been, while at the same time, bond maturities in the bond index are as long as they have ever been—at 7.2 years. This means more risk and less protection if rates rise dramatically.

Investors may want to consider replacing bond funds that have interest-rate risk for those with credit risk. A couple of examples are floating-rate bond funds and high-yield bond funds. Both categories of funds are better suited for a rising rate environment because their yield cushion is much higher (between 4 percent and 6 percent), while their sensitivity to interest rates is significantly lower.

A few possible choices to consider are Ridgeworth Seix Floating Rate High Income or Eaton Vance Floating Rate. For high-yield bonds, consider the Vanguard High-Yield Corporate funds sub-advised by Wellington Management or Mainstay High Yield. These suggestions do reduce interest-rate risk but have the downside of greater volatility and more correlation to stocks.

2. Reduce exposure to interest-sensitive equities. Consider reducing your exposure to U.S. real estate investment trusts, utility stocks and high dividend-paying equities, as these are sensitive to rising interest rates. While they have enjoyed several years of great performance as interest rates fell broadly, that party may be ending soon.

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The problem is that REITs are expensive and have little yield cushion. While utilities have a slightly higher yield, they are heavily regulated and their prices have been bid up significantly in the past year.

For high-dividend mutual funds and ETFs, it's important to know what you own. Companies can, and have, raised dividends in the past few years, yet many of the highest-yielding stocks have been bid up to levels that make holding these companies less attractive.

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3. Consider reallocating to small company and foreign stocks. With the runup in U.S. large company stocks, your portfolio likely has too much exposure there and too little exposure to small company and foreign stocks.

It may be time to consider reallocating some of your U.S. equity exposure. Why? Smaller U.S. companies don't face the same currency headwinds that have negatively impacted large U.S. multinational companies, such as Intel, IBM, McDonalds, Fedex, etc.

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Instead, small companies do most of their business in the U.S. in dollars. Also, large U.S. companies (think S&P 500) have dominated in performance, while small- and mid-cap stocks have lagged recently.

You may also want to consider increasing your exposure to foreign stocks. This may seem counterintuitive in the current environment of a strong and rising U.S. dollar, but there are a few things working in your favor. The first is the steep decline in the euro and yen. Weaker currencies have made European and Japanese goods and services much more competitive as compared to U.S. companies'.

"You may also want to consider increasing your exposure to foreign stocks. This may seem counterintuitive in the current environment of a strong and rising U.S. dollar."

This bodes well for future orders and profitability for foreign-based companies. Second, many investors hold a negative view about investing money outside the U.S., because of fear of the "rising dollar." This is why foreign stocks are generally less expensive than stocks in the U.S., making them a better bargain.

4. Hold some cash for future reinvestment. Cash doesn't currently pay much, but once the Fed begins to raise short-term rates, it will likely do so in a steady and measured manner until it reaches the desired outcome level. Setting aside some cash may cost you in the short term, but if rates rise a full percentage point or more, this money will be available for investment at higher yield levels.

—By Barry Glassman, founder and president of Glassman Wealth Services.