How to Take Advantage of the Inevitable Rise in Interest Rates

By Sasha Cekerevac

Many people are only just now coming to understand something I’ve been warning about for several months: interest rates are set to rise.

In the month of June, there was a record amount of money pulled out of bond mutual funds and bond exchange-traded funds (ETFs).

According to TrimTabs, a total of $70.8 billion exited bond mutual funds, with an additional $9.0 billion of assets being pulled out of bonds ETFs. That $80.0 billion in total assets being pulled out of the fixed-income asset class was almost twice as large as the pullout that occurred in the fall of 2008, the previous record of monthly outflows. (Source: “Unprecedented $80 Billion Pulled from Bond Funds,” CNBC, July 1, 2013.)

Also Read: NYSE Holidays 2013

Obviously, long-time readers of mine won’t be surprised, since I’ve been recommending adjusting one’s investment strategy to incorporate higher interest rates for several months now.

Even just over a month ago, when 10-year interest rates crossed the two percent barrier, I wrote in the Investment Contrarians article “Why U.S. Treasuries Are Still the Worst Investment” that my analysis had led me to conclude that interest rates were set to continue rising. Even at that time, I was urging readers to incorporate this into their investment strategy.

At the time, many so-called “market experts” thought that interest rates would begin to fall and test the lows of the year. My argument has been that we’ve seen the lows of this cycle, and interest rates for the next few years will begin to rise significantly, especially on the long end of the curve.

Clearly, we are not Japan, because there are already signs of our economy improving. In addition, the Federal Reserve has been much more aggressive over the past few years in trying to promote economic growth. Only now, after decades of inactivity, has the Bank of Japan embarked on an ultra-aggressive monetary policy similar to what the Federal Reserve has been doing over the past few years.

Chart courtesy of www.StockCharts.com

The above long-term chart of interest rates for the 10-year U.S. Treasury shows that even though the move has been substantial, interest rates are still historically very low.

It is important to note that interest rates will adjust in different measures along the fixed-income curve, so investors need to be careful in their investment strategy allocation. The Federal Reserve will stop its asset purchase program over the next year; however, they will keep the Fed funds rate, which is for extremely short-term overnight lending, at very low levels likely until 2015.

That means short-term interest rates won’t move as much as the long-term end of the curve. Personally, as an investment strategy, I have been recommending investors move out of very long-term interest rates, such as the 10-year note or 30-year bond, and to essentially keep cash on hand in short-term investments for when interest rates rise. Over the next few years when rates begin to rise, investors should then reallocate an investment strategy to lock in higher interest rates.

The recent up-tick in interest rates could be used by fixed-income investors to allocate funds in relatively short-term paper, such as a two-year note—and when this investment matures, we would have an environment of much higher interest rates to roll these funds into a long-term fixed-income asset.

This article How to Take Advantage of the Inevitable Rise in Interest Rates was originally published at Investment Contrarians