Summary

• Shorten bond durations and pick higher coupon issues, even at a premium.
• Find low-risk equity substitutes for bonds.
• Pick equities of companies that will benefit from higher rates.
• Avoid companies with high debt, or look for those with fixed-rate debt and ability to pass on inflationary price increases.

As nearly everyone is aware, the Fed is considering ending its quantitative easing program, and even raising interest rates. They are telegraphing this well in advance, as after years of a zero interest rate policy, they do not want to shock the recovering economy. Wise investors will prepare for this eventuality in advance, and make tactical changes to their portfolios to prepare for an eventual increase in interest rates. These changes are especially important for income investors, who are likely to have the highest exposure to the bond markets.

Bond Portfolio Changes

The most obvious way of countering rising interest rates is to lower the duration of bonds in a portfolio. Bond prices move inversely to yields. That means when interest rates go up, bond prices decrease. This makes intuitive sense, as you would not be willing to pay full price for a bond paying 2% interest if you could receive 5% interest on a new bond; you would expect a discount to make up for the lower interest rate. The longer the remaining term of the bond, the more low rate interest payments that need to be made up for with the discount. Thus, longer duration bonds have more exposure to rising rates, and should be replaced with shorter duration bonds in a portfolio.

For ETF investors, switching from a mixed fund such as Vanguard Total Bond Market (NYSEARCA:BND ) into something with a shorter duration, such as Vanguard Short-Term Corporate (NASDAQ:VCSH ) may be wise. Although the SEC yield of the shorter-term fund is lower by 0.82%, its average duration is 2.9 years versus 5.6 years, which means it has lower risk of loss from rising rates.

Another factor to consider in a bond portfolio is convexity, which can be roughly defined as the rate of change of a bond’s price given a change in yield. More information on how this works graphically can be found in this tutorial. The less academic take away from the concept of convexity is that higher coupon bonds are less susceptible to changes in interest rates. Thus, if you bought $10,000 of bonds with the same yield to maturity, the bond with the higher coupon will generally have less of a price change with a given change in yield.

Taken to the extreme, zero coupon bonds have the greatest convexity conventionally available, and their prices move greatly with changes in interest rates. Investors in individual bonds may wish to substitute low coupon issues with high coupon issues, even though they’ll be required to pay a premium for these issues, as it reduces the scale of loss if interest rates rise. This has the side benefit of providing more current income to income-challenged retirement investors, although it does so at the cost of principal erosion.

The final way investors can reduce interest rate risk in a bond portfolio is to increase exposure to high-yield bonds. These bonds pay higher coupons, so they have lower interest rate risk than investment grade bonds. Additionally, the economic improvement most likely to lead to higher interest rates may improve the ability of these firms to make their debt payments, reducing defaults, which are the main risk to this strategy. A junk bond portfolio should be diversified and exposed to positive credit events. One method of doing that is described here. or investors may prefer to use an ETF such as the SPDR Barclays Capital High Yield (NYSEARCA:JNK ).

Bond Substitutes

Investors may also want to substitute for their traditional bond exposure. While chasing yield into high cost MLPs has been popular for the last few years, those instruments have the potential to be significantly hurt when rates rise, as their debt will cost more and investors will demand a higher yield as straight bonds re-emerge as an alternative.

A better option is companies with bond-like characteristics. The ideal company for this is one with a growing, diversified stable business stream and the ability to reinvest its capital at acceptable rates of return. Berkshire Hathaway (NYSE:BRK.A ) (NYSE:BRK.B ), fits the bill best. Insurance companies (historically the largest division) are bond substitutes in general, as they often have large fixed income portfolios. Berkshire is currently investing large sums of capital in its railroad and utility divisions, and the utility continues to regularly make large acquisitions. One example is its recent purchase of AltaLink. an electricity transmission business in Canada with a regulated return on capital. As the company puts more and more capital to work at fixed rates of returns, its equity becomes more and more like a bond, with a higher than average yield and the best investor in the world managing it.

Investors may also want to consider other insurance companies. Factors to look for are low Price/Book ratios, good returns on equity, and combined ratios near or below 100%.

Higher Rate Beneficiaries

Investors may also want to purchase shares in companies that will benefit from higher rates as a way to hedge their exposure to rising interest rates. Investors can look for companies that make their money lending out money at variable rates, and companies that make a spread on low-yield instruments. One example of the first type of company is Interactive Brokers (NASDAQ:IBKR ), which I profiled here. It earns a significant portion of its profits from lending money on margin to its clients. As interest rates rise, it will be able to raise its margin rates and improve the return on the significant amount of excess capital.

Other companies that will benefit from higher rates are the custody banks, such as the State Street Corp. (NYSE:STT ). These banks have huge amounts of deposits currently earning very low returns, as interest rates are very low. Their deposits come from their custody franchise and are very sticky, so as rates increase, their spread will increase as well. Seeking Alpha author Joseph Harry has a comprehensive look at STT here .

Investors should look for companies with high cash balances, investable float, and variable rate lending for this portion of their portfolio. Please feel free to add your suggestions for companies that will benefit from higher rates in the comments section.

Evaluate Stock Positions

Investors may also want to re-evaluate any existing stock positions. Companies with high debt and near-term maturities will be at risk if credit markets tighten or rates rise. Investors, especially those approaching retirement, may not wish to take on that risk. While high-debt firms are currently over-earning due to the low cost of debt, this is analogous to picking up pennies on the train track; eventually the 4:05 rolls through.

Investors who need the yield that leveraged firms like REITs can provide should look for firms that have long-term fixed-rate debt. Another advantage is the ability to pass along inflation-based cost increases to customers. One great example of these two features is Pure Industrial REIT (OTC:PDTRF ), which I profiled extensively .

Lock in a Mortgage

While this is not a traditional investing move, it may make sense for investors who believe rates will rise. A 30-year mortgage is equivalent to a very long duration bond, except in reverse. Borrowing money at rates when those rates are at a generational low is relatively conservative. Homeowners should consider whether locking in floating or reset loans makes sense. While this may cost more initially, it has the potential for significant long-term savings in a rising rate environment, and is a reasonable hedge to a bond portfolio.

Conclusion

Income investors are at significant risk from rising rates, but there are actions they can take to re-work their bond portfolio. Additionally, an equity allocation can be used to effectively hedge and benefit from higher rates, which has the potential to offset interest rate losses in the bond portion of a portfolio. While this article does not make a forecast for interest rates, wise investors will consider their overall exposure to interest rates when making security selections.

Disclosure: I am long PDTRF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.