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4 Rules for a New Era of Interest Rates

There’s time to prepare your portfolio for an eventual turn in rates


youngInvestorsB.pngI view the recent turmoil in the bond market as a warning shot across the bow.

If you missed it, for the past few years the Federal Reserve has kept Treasury bond rates artificially low. But this summer, bond yields hit their highest level in a year, which is seen as a bad sign for stocks — though on Monday, Sept. 16, investors breathed a sigh of relief and bond prices started to turn back down again after one of the candidates for current Fed Chairman Ben Bernanke’s position withdrew from consideration.

So what does this mean when it comes to your portfolio?

At some point, the unemployment rate will slip far enough — and retail prices will climb fast enough — to ring alarm bells at the Fed. Bernanke (or, more likely, Bernanke’s successor) will tighten credit.

The first turn of the screw probably still is at least a year away. When it comes, though, it will signal a momentous trend change for interest-sensitive investments of all kinds — from bonds and high-yielding stocks (such as utilities) to real estate. A new era of rising interest rates will have begun. It will continue, if previous cycles are any guide, for the next 20 to 30 years or more.

Fortunately, we’ve got time to prepare. As I just noted, the Fed is in no hurry to act. Moreover, even after the primary trend shifts to the upside for interest rates at all maturities, there will be numerous pullbacks as the economy undergoes periodic slowdowns. These temporary dips will give you a chance to exit bonds and other interest-sensitive assets before the next spike in rates pushes prices back down.

Still, it’s not too early to begin allocating your new money (i.e., savings) differently from the old era of falling rates. Here are four guidelines to follow:

Emphasize investments that can deliver a rising stream of income over time.

Common stocks are the classic prescription, but many stocks in today’s market pay skimpy dividends or none at all. In addition, of those companies that do sport reasonable yields, not all are poised to grow their dividends faster than the cost of living. As a rule of thumb, I advise you to focus your buying on stocks that toss off a current yield of 2% to 4%, with a five-year history of fattening the dividend at a pace comfortably exceeding the inflation rate.

Make liberal use of tax-efficient vehicles to squeeze out extra income.

I’m thinking specifically of master limited partnerships and real estate investment trusts. These entities are largely exempt from federal income tax at the corporate level. As a result, they can pass along more of their earnings to you, the investor.

By holding your REITs inside a retirement account and your MLPs in a taxable account, you maximize your ability to reinvest your earnings — a powerful compounding technique that accelerates your growth.

Favor short to intermediate maturities in your new bond purchases.

In an environment of gradually rising interest rates, shorter maturities will allow you to roll over your principal more frequently, at higher yields. Nothing wrong with that! My top bond buy this month is PowerShares Senior Loan Portfolio (BKLN). This exchange-traded fund invests in secured (collateralized) bank loans whose interest rate resets, on average, every 26 days. Current yield: 4.3%.

Adopt a trading mentality with regard to long-dated bonds.

From 1981 to 2012, the best strategy with bonds of a long maturity was to buy and hold. In the coming era, you can still make money with long bonds, but only by “renting” them for short periods of, say, six to 12 months.

Interest-rate hysteria, coupled with fear of the “Detroit disease,” has abnormally depressed municipal bond prices and pushed up yields. For instance, BlackRock MuniHoldings Investment Quality Fund (MFL) is yielding 7% tax-free — a spectacular payout for a portfolio concentrated almost entirely in high-grade bonds.

I don’t recommend holding long-dated funds forever. Once the bond market recovers its equilibrium, whittle down your stake in long-dated funds. In the meantime, though, we’ve got a chance, as traders, to earn some of the highest yields of the past two years, with the prospect of decent capital gains within the next few months.

Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk value approach has won seven Best Financial Advisory awards from the Newsletter and Electronic Publishers Foundation.

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