How to Position Your Nest Egg for Rising Rates

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Long-term interest rates have hit their highest levels in nearly two years, signaling at long last the likely end to what has been a brutal period for savers and income-seeking retirees.

The benchmark 10-year Treasury bond yield has jumped above 2.5% from a low last year of around 1.4%, with most of that move coming just since May. By historical standards, this remains a pathetically stingy payout. But signs point to a sustained rise ahead, which would change the game for anyone who is investing for income or living off their accumulated assets.

Let’s be clear: From a saver’s point of view, rates on fixed-income products across the board remain oppressively low. Even as long-term rates have pushed higher, savings rates have continued to wallow near all-time lows. Money-market accounts pay an average 0.1%; bank CDs maturing in three years or sooner offer less than 0.5%. To put such low yields in perspective, if you have $100,000 in a three-year CD, the annual income is just $500—enough, maybe, to cover your cell phone bill. Low rates will continue to challenge passive income seekers for many more months, and possibly even years, to come.

But a shift is occurring. The Federal Reserve has said it may begin to taper off its massive $85 billion a month bond purchases late this year, and end the program in 2014, if the economy shows further signs of sustaining its recent momentum. The latest readings suggest that’s practically a sho0-in: Housing prices jump 12% in April, the biggest annual gain in seven years. As the Fed winds down its bond purchases, long rates should rise across the spectrum. Sometime after that–maybe in 2015–look for short rates to rise as well, lifting yields on things like savings accounts, bank CDs, money market accounts, short-term bonds, and fixed annuities.

So the challenge today is two-fold: How do you find decent income while rates remain abysmally low, and how do you get positioned to capture higher yields when they arrive?

It’s a tricky issue because as interest rates rise, bond prices fall — and in some cases the losses from slumping bond prices can overwhelm anything you’ve collected in interest payments. “A rise of just one fifth of one percentage point in interest rates would mean the loss of an entire year’s return on current long-dated Treasuries,” BlackRock CEO Laurence Fink recently warned. In his view, long-term government bonds are now as risky as stocks, if not more so. Indeed, T-bonds have lost 10% of their value the past two months, reflecting similar near-term losses in many types of bonds and bond funds.

Rising rates also take away some of the momentum from dividend-paying stocks, which had been on a tear as retirees turned to them for more income than was available through traditional fixed-income vehicles like bonds and CDs. Dividend payers may be falling out of favor now as bond yields rise enough to offer a competitive income.

Keeping all that in mind, here are four strategies for positioning your retirement savings during a period of rising rates.

1) Shift from bonds to fixed annuities

One way to approach this puzzle is by shifting some money from government bonds to fixed immediate annuities. From 2008 through 2012 investors poured more than $1 trillion into bond mutual funds. It paid off as falling rates sent prices higher and boosted bonds’ total return. But that trend is reversing now.

Income-seeking retirees should lighten up on bonds and purchase a fixed annuity, says Katie Libbe, vice president of Consumer Insights for Allianz Life Insurance of North America. “The only way to secure retirement income is to own a product that offers guarantees,” she says. “And the only way to guarantee that income will last for life is through an annuity.”

Fixed annuities remain relatively expensive in terms of how much income you can purchase. A 65-year-old couple would have to pay $100,000 for a fixed immediate annuity that provides $471 a month until both parties have passed away, according to Annuities are an insurance product, not a bond. So there is no erosion of principal as rates rise.

“This payment structure can help with the budgeting process in retirement and make sure that people have enough income for basic living expenses,” notes Libbe. If you lean toward shifting from bonds to fixed annuities, consider doing so in two or three steps. As rates rise, you’ll buy more income for the same price. So consider selling some bonds and parking the proceeds in a money market account, then averaging into fixed annuities over the next 12 to 18 months.

2) Shorten bond maturities

Another approach to consider is to lighten up on long-term government bonds, which are especially vulnerable to higher interest rates, and switch to shorter maturities. You’ll give up some yield. But you don’t have to worry about falling prices if you can hold the bonds until they mature and your principal is returned.

“We’ve been shortening durations for two years, expecting rates to rise,” says Jorge Padilla, financial adviser at Lubitz Financial Group in Miami. He advises clients to create a bond ladder, putting money in a several groups of government bonds that mature in, say, one, two, three, and four years. As the bonds mature each year, you reinvest the proceeds in another four-year bond.

That way you capture the higher yield on longer-term bonds and still have access to principal every year. The proceeds from maturing bonds can be reinvested at even higher yields in a rising rate environment. Short-term bond funds accomplish much the same thing. Such ladders also work with short-term income needs, using bank CDs that mature, say, in one, three, six and 12 months.

3) Don’t give up on corporate bonds

All bonds are not equal. The higher yield on blue chip corporate bonds, and even higher yield on riskier “junk” bonds, offer investors a significant cushion against rising interest rates. These bonds offer so much more income than government bonds that the potential loss of principal in a rising rate environment is of less concern. The average yield on corporate high-yield bonds is more than 7%, nearly triple that of the 10-year T-bond.

In addition, high-yield bonds often trade more like stocks than bonds. That’s because their value is hinged to how well the business does. Prices might even rise along with interest rates if accompanied by a stronger economy, as is often the case. Padilla says high-yield bonds (as well as dividend-paying stocks) remain a core part of his rising-rate strategy.

Interest rates generally rose from 2004 to 2006 and in that period high-yield bonds returned about 18% while government bonds returned about 2%. The risk is that the economy turns down again, in which case high-yield bonds (issued by less creditworthy companies) likely would take a tumble. Diversification across multiple industries is the key. Consider high-yield mutual or exchange-traded funds.

4) Get inflation protection

For now, inflation is tame and remains far from most investors’ radars. There is no reason to suspect it will be a problem in the next year or so. In fact, a major goal of the Fed allowing rates to rise is to keep inflation at bay. Still, rising rates and inflation sometimes go hand in hand.

To mitigate the risk of rising rates consider investments where the yield tracks with inflation. These include real return mutual funds, which invest in floating-rate loans; real estate; and commodities. Consider also widely used Treasury inflation-protected securities, or TIPS. These are government bonds adjusted twice a year for inflation, which ensures that coupon payments will rise in an inflationary environment.

There is no guarantee that rates will keep moving higher. With parts of Europe in recession and growth slowing in China, the U.S. economy may falter again, or at least fail to catch fire. And the Fed may not begin tapering its bond-buying program as soon as markets seem to be anticipating. That’s why income-seekers cannot simply stand by and wait for higher yields.

You need to do the best you can with things like fixed annuities and bond ladders, and with dividend stocks and high-yield bonds, which have stumbled a bit lately but should remain part of a diversified income portfolio. Rates are almost certainly headed higher in coming years. Now is the time to get positioned for that important change.

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