How to swim with the tide when interest rates rise

Rising interest rates threaten to savage the investor unprepared to navigate a new economic era.

For mutual funds, the second quarter was a case of resilience or lurking danger - exactly the kind of contrary sentiments one might expect at the beginning of a sea change in the investing environment.

Those in the resilience camp point out that funds did manage to weather a series of negative developments, including interest-rate hikes, rising prices - especially for things like gasoline - instability in Iraq, and the uncertainty of a presidential election.

Meanwhile, people who see lurking dangers note that, after four straight quarters in which US stock funds rose an average of 9.5 percent every three months, the average stock fund barely managed to break even. It gained just 0.84 percent from April through June, according to Lipper. Some fund categories, including those that invest in regions that had been doing well, were negative.

In short, the market is leery. Rising interest rates could savage investors. "People have become more cautious just over the past month or two," says Amy Arnott, a senior analyst at Morningstar. "They seem to be shying away from some of the pricier stocks in the market and [moving] more toward value, because of concerns about rising interest rates as well as general economic concerns, and concerns about geopolitical issues."

As is always the case, some types of funds will perform better than others. Last quarter, for example, growth funds outperformed value funds for most of the period, but came up short near the end as investor worries helped value funds, whose prices tend to be less volatile.

The average value fund gained 1.3 percent over the past three months, while the average growth fund was up just over half a percent, according to Lipper.

One of the looming challenges facing investors in coming months, experts say, is how to invest in an economy where, for the first time in two decades, interest rates look more likely to rise than to decline.

That shift represents a key change in the investing environment because interest rates play such a vital role in the economy. When they're set low, they fuel growth because people and businesses are willing to borrow cheap money to build, buy, or invest. When they're set high, they choke growth that central bankers believe has gotten out of hand.

By raising interest rates, the Federal Reserve Board has taken a step away from the era of cheap money that helped the economy stay afloat during difficult times. If the trend continues, then investors will have to adjust their portfolios to avoid the dangers of higher rates and more expensive money, investment experts say. Fortunately, there are ways to cope, they add.

The Federal Reserve Board waited until the last day of June to raise the federal funds rate, its benchmark short-term rate, a quarter of a point, to 1.25 percent. The previous rate of 1 percent had been in place for more than a year.

By the end of this year, this rate could reach 2.25 percent, says Robert Auwaerter, head of fixed-income portfolios at the Vanguard Group in Valley Forge, Pa.

The bond market has not waited for the Federal Reserve to act. For more than a year, it has been busy raising longer-term interest rates on its own. At approximately 4.45 percent, the yield on the 10-year Treasury note is 1.5 percentage points higher than it was in June of last year, Mr. Auwaerter says.

Since bond fund prices go down when interest rates go up, the quarter was not kind to most bond funds. The average intermediate-term bond fund lost almost 2.3 percent, according to Morningstar, while the average long-term government fund lost more than 4.1 percent.

These declines have been difficult for bond-fund investors, but Mr. Auwaerter thinks the worst may be over. While the Fed is likely to continue raising rates over the next year or so, he does not think inflation will surge ahead and therefore does not foresee a dramatic rise in Treasury rates.

"If somebody is looking to put money to work in fixed-income, now is better than would have been the case back in June of last year," he says.

Also, because they are lenders, shareholders in bond funds benefit from higher rates over the long run because they mean higher yields, he notes. If an investor needs his or her money soon, rising interest rates will hurt. But, if the investor won't need the money for several years, the higher yield - as long as it's reinvested - can more than make up for the erosion of principal, he says.

Three categories of fixed-income investments should be considered in a rising interest-rate environment, says Edward "Ted" Wiese, senior portfolio manager at T. Rowe Price in Baltimore: short-term bonds; cash, represented by money market funds; and high-yield, or "junk" bonds. Over the past 30 years, these categories have consistently outperformed other groups when interest rates rose, he says.

• Short-term bonds. Prices of short-term bonds and bond funds do go down when interest rates rise but, over time, their higher yields usually result in higher total returns. Also, bonds maturing in five years or less make up the bulk of most short-term fund portfolios. These bonds should outperform longer-term bonds in a rising rate environment, Mr. Wiese says.

• Money-market funds. With seven-day average yields running at about 0.60 percent or less, money market funds have not been attractive for some time. However, if preservation of principal is important, investors may be willing to sacrifice yield in exchange for safety, for part of their money, at least. Also, money-fund yields rise and fall in response to the Fed's moves, with about a 50-day lag, Wiese notes. If that's the case this time, these funds could be yielding 2 percent or more a year from now.

• High-yield bond funds. These funds carry the most risk, because their returns tend to mirror the fortunes of the stock market and the economy. But if the economy continues to improve and the stock market gets out of its current rut, which Wiese expects it to do, these funds should do well, thanks to their higher yields and the stronger balance sheets of companies issuing high-yield debt.

For stocks, the advice isn't so clear-cut.

Up to a point, experts say, moderately rising interest rates and a slight increase in inflation are not a problem for the stock market or the economy, because they give companies pricing power and can lead to more profits.

So far, they say, rising interest rates are a reflection of healthy demand, and not a result of the Fed moving to cut off inflation.

At this point in the recovery, cyclical stocks usually outperform the market as a whole. These stocks, which include housing, steel, automobiles, and paper, tend to rise quickly during economic upturns and fall during downturns.

Lately, some other stocks have been outperforming.

"Natural-resources stocks have been doing well, with rising oil and gas prices," says Ms. Arnott at Morningstar. "Also, most of the retail stocks have been doing relatively well because consumer spending has been picking up."

Investors who have well-diversified portfolios probably can sit tight. If they do make changes, experts say, they should consider moderate shifts in their allocations, keeping in mind any transaction costs and tax consequences.