Smart Moves for Tomorrow's Higher Interest Rates
Luke Mullins and Rob Silverblatt

 

Although the economic crisis has gutted home values and sent unemployment surging, not all of its outcomes have disadvantaged consumers. As the financial system imploded in late 2008, yields on 10-year treasury notes -- a key benchmark for longer-term interest rates -- fell to an average of 2.18 percent for the last week in December. That was the lowest level in nearly 50 years, according to HSH.com. Although yields have since bounced back, a number of forces have converged to keep them at historically depressed levels: The slack in the American economy has overwhelmed inflation concerns. Periodic bouts of fear -- most recently surrounding Greek debt -- have driven inventors to the safety of low-risk investments, like U.S. treasuries. Meanwhile, the Federal Reserve has slashed its benchmark interest rate to as low as zero while launching a program to buy up hundreds of billions of dollars in long-term treasuries.

For the week ending April 30, 10-year treasury yields were still only 3.76 percent. That's significantly below the 6.5 percent yield they averaged during the 1990s, according to Richard DeKaser, the president of Woodley Park Research. While these artificially low rates point to a weakened economy, they have provided a temporary boon for many home buyers and borrowers. But as the economic recovery picks up steam, longer-term interest rates are expected to steadily march higher. "I don't expect it to be a dramatic, huge move all at once," says Mike Larson of Weiss Research. "But I do think that a lot of forces pretty much across the board are lining up for higher interest rates for the long term."

The trend is linked to the economic recovery. The Fed has already ended its purchases of treasuries and is expected to slowly begin raising interest rates around the end of the year. The improving economy, meanwhile, will revive concerns about inflation and bolster loan demand. "We are looking at increased demand for credit, and that will drive up interest rates," DeKaser says. At the same time, massive federal budget deficits mean that Uncle Sam will continue to issue vast quantities of debt. But as the global recovery opens up new money-making avenues, treasury yields may have to increase to attract investors. "The fact is we are going to be continuing to flood the world with debt," says Keith Gumbinger of HSH.com. "It can't always and forever be low-yielding debt if we expect to continue to find an audience for it."

How high will rates go? DeKaser projects 10-year treasury yields to finish 2010 at just under 4 percent, before rising to 5.24 percent at the end of 2011 and 5.56 percent at the end of 2012. Here is a look at seven moves consumers can make ahead of the upcoming rate increases:

1. Buy a home.

Since fixed-mortgage rates typically track 10-year treasury yields, home loan costs have been extremely attractive recently. Thirty-year fixed mortgage rates averaged 5.15 percent in the week ending April 30, down sharply from 6.23 percent three years earlier. Although financing costs are just one of the handful of considerations that go into a home-buying decision -- the most important of which is your employment situation -- low mortgage rates certainly make purchasing real estate more tempting. "If you are looking at the long-term outlook, this is a fantastic time to get into the [real estate] market because you have that double support of cheap pricing and cheap financing," Larson says.

2. Refinance your mortgage.

At the same time, any homeowner who can benefit from the lower mortgage rates -- but hasn't done so already -- should consider refinancing their home loan. "The consensus is [mortgage rates] have bottomed out," says Guy Cecala, the publisher of Inside Mortgage Finance. And while homeowners looking to refinance will still need sufficient credit and home equity, Cecala says today's refinancing environment can actually benefit them. "You have definitely seen a reduction in the number of fees that [lenders] charge," Cecala says.

3. Tweak your bond portfolio.

Most investors will find that their bond holdings are the most vulnerable parts of their portfolios during periods of rising interest rates. That's because increasing rates translate into lower bond prices. Still, there are ways investors can plan ahead. One of the more basic things to remember is that bonds with shorter durations are less sensitive to rate hikes. If you feel that higher interest rates are imminent, then "the first thing you would do is to reduce your [average] duration," says Todd Burchett, a bond fund manager for ICON Advisers. For mutual fund investors, short-term bond funds are among the most common means of doing so, and making moderate allocations to them can help ease the transition into higher rates.

4. Float to safety.

Another option is for investors to put a piece of their portfolios in floating-rate mutual funds. These funds can act as a shield since the amount they pay out to investors resets periodically. If rates increase, so do payouts. "When rates go up, your income goes up with them because your coupon will reset," says J. David Hillmeyer, a comanager of the Delaware Diversified Floating Rate mutual fund."That provides a buffer in a rising-rate environment." The downside to these funds, though, is that they are often heavy on so-called "junk" bonds. "They've had a very good year in 2010 and they did very well in 2009," Jeff Tjornehoj, Lipper's research manager for the United States and Canada, says of floating-rate funds. "But they really had the rug pulled out from under them in 2008."

5. Start thinking about inflation.

Long-term interest rates often go up when investors are worried that inflation is looming. At the moment, it's unclear how much of an issue inflation will be over the next few years, but given the government's ballooning deficit, it's a subject that is at least worth considering. Investors who are worried about inflation can find refuge in a number of investments, such as Treasury Inflation-Protected Securities, which are government-backed bonds whose principals are adjusted for inflation. Gold is also an option. That doesn't mean it's necessary to take the plunge right now, but it's never too early to start developing a plan to protect yourself from inflation.

6. Some more exotic options.

For aggressive investors, there are some ways to actively cash in on rising rates. Two common examples are shorting bonds and investing in inverse bond funds. In both instances, investors are rewarded if bond prices fall (which will happen when interest rates spike). Still, these are risky bets that require precise timing, and investors often make them for the wrong reasons. "People sometimes pick up these instruments because they're guided by emotion rather than rational arguments," says Tjornehoj.

7. Pay off credit card debt.

For cash-strapped Americans who are struggling to pay down credit card debts, things could get worse as interest rates creep up. "As longer-term interest rates go up, issuers will take that into account," says Bill Hardekopf, the chief executive of LowCards.com, a company that analyzes and reviews credit cards. "[Cardholders] can expect to have a higher APR." As a result, Hardekopf says that cardholders should make an extra effort to pare down their debt while rates are still artificially low. "Anyone carrying a credit card balance from month to month should pay that thing off," he says. "That's especially true if the interest rates are projected to go up."

 

 

Smart Moves for Tomorrow's Higher Interest Rates

 

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