Diana Olson
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How to invest like it's 1979: Rising rates and big hair

If you lived through the 1970s, one of your greatest sources of astonishment is probably that interest rates aren't soaring. In that carbuncle of a decade, you counted yourself fortunate if you got a mortgage at 12%, and cursed your money fund if it paid less than 10%.

Nowadays, you're still cursing your money fund, which pays nothing. But rather than feeling cheerful about 30-year mortgages at 4.10%, you worry that interest rates are going to rise, and soon, and rapidly. You may also fear that the Starland Vocal Band will re-form.

But with interest rates somewhere in the fifth sub-level of the financial world's parking garage, it's a good bet that sooner or later, interest rates will rise. The question is how to position your portfolio for higher interest rates — if, in fact, you should.

You can divide interest rates into two parts. Short-term interest rates are largely controlled by the Federal Reserve. Its key fed funds rate is between zero and 0.25%. The Fed has said that it will probably not raise short-term rates until next year, depending on the outlook for the economy and inflation.

You may rail that inflation is higher than the Fed (and Wall Street) thinks it is, but the fact that you're unhappy about the price of eggs probably won't dissuade them. The consumer price index, the government's main price measure, has gained 2% the past 12 months. The Core PCE deflator, the Fed's favorite measure, has gained 1.5% through June. That's not high enough to ring alarm bells at the nation's central bank.

In any event, you can't have a wage-price spiral without a sharp increase in wages. If you've demanded a 5% raise from your boss recently, you can probably still hear his merry trills of laughter as you headed back, red-faced, to your desk. Job growth is simply too low for a wage spike.

Long-term interest rates are largely controlled by the bond market, although the Fed has intervened heavily there as well. Its program of purchasing long-term bonds and mortgage-backed securities should end by October. But even as the Fed has tapered its bond-buying program, rates have fallen. The benchmark 10-year Treasury note yield ended 2013 at 3.03% and closed Thursday at 2.33%.

You can thank Vladimir Putin and the many people fighting in the Middle East for low long-term rates. You may think that the U.S. government has too much debt, and it does, but U.S. debt yields more than Germany's or Japan's, and we have a sterling credit record and a honking big military. When the going gets tough, the timid buy Treasuries.

Sooner or later, however, interest rates will rise. You'll notice two immediate effects:

• When the Fed raises interest rates, you'll get better yields on money market funds and bank CDs. (Better, in this case, means "more than nothing.")

• You'll get higher yields but lower prices on your bond funds. Bond prices fall when interest rates rise, and your higher yields won't be enough to offset your fund's share price.

You can get some idea of how badly your fund will get hit by a figure called duration, which most funds supply in their literature. A fund with a duration of 3.5 years will fall 3.5% for every percentage point rise in interest rates.

Stocks, however, don't necessarily fall when interest rates rise. Rising rates mean a greater demand for loans, which is an indicator of a growing economy. Typically, the stock market initially views the start of a Fed interest rate increase positively — a token that things are headed back to normal after a recession. It's not until the Fed has hiked rates repeatedly that the stock market starts to get uneasy — the origin of a once-useful rule called "Three steps and a stumble." The rule says that after the Fed has raised its discount rates three times, stocks fall.

The rule doesn't seem to apply when interest rates are exceptionally low. The Fed raised its discount rate in three steps from 2% in June 2004 to 2.75% in September of that year. The next 12 months, the Standard and Poor's 500-stock index rose 10.3%. The Fed's rate-hike campaign didn't end until June 2006, when it pushed the discount rate to 6.25%. Stocks continued to rise until October 2007, when they entered the biggest bear market since the Great Depression.

So how should you prepare for a rise in rates? If you want to reduce interest-rate risk for your bond funds, consider a CD ladder instead. (You can do the same with bonds, if you want.) You start by dividing the money you'd normally keep in a bond fund into five CDs, each of which matures one year later than the next. When the one-year CD matures, roll it into a five-year CD. You'll do this until you're continually rolling over five-year CDs. You'll continually lock into the highest current CD rates without losing principal, assuming you don't incur any early-withdrawal penalties.

If you're a stock investor, your biggest fear should be a period of rising inflation and rising interest rates — in which case, both stocks and bonds will let you down. What can you do?

• Increase the percentage of your portfolio devoted to money funds. Your yield will rise as the Fed raises rates.

• Look for a high-quality, short-term bond fund, such as Vanguard Short-term Bond ETF (ticker: BSV) or iShares Barclays 1-3 year Credit Bond Fund (CSJ).

• Consider adding a fund that invests in Treasury Inflation-Protected Securities (TIPS), such as PIMCO 1-5 year TIPS Index fund (STPZ). TIPS' principal rises alongside the consumer price index.

You might also consider adding a 5% position in gold as insurance against inflation. The easiest way to own gold is through a mutual fund, such as iShares Gold Trust (IAU).

If you're a long-term investor, though, your best protection against a period of high interest rates and high inflation is time. The yield on the 10-year Treasury note rose from a low of 3.85% in December 1962 and soared to 15.84% by August 1981. During that period, you would have earned an average 7.7% a year from the S&P 500, assuming you reinvested dividends. And you would have beaten, albeit narrowly, Treasury bills (6.4%) and inflation (6.1%). It was a white-knuckled ride, replete with big bear markets, big interest rates and big hair, but ultimately, it would have kept you staying alive.

Source: usatoday.com