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What to do about low interest rates

Last week’s Treasury auction drove interest rates to record lows, with 7-year notes yielding just 2.01% (the lowest since last October) and yields on 10-year notes driven down to 2.425%, down from about 3.0% in January. That sag in rates has produced strong returns in bonds and bond funds, with the Barclays Aggregate Bond Index up 3.80% year-to-date. It presents more of a problem for retirees who rely on income from bonds.

Still, what goes down must eventually go up. Stanford Professor John Taylor, who devised the Taylor rule to calculate equilibrium interest rates based on inflation and economic activity, says that the Federal Funds rate, now at zero, should actually be around 1.25% now. Taylor isn’t arguing for a sudden move to 1.25%, but he thinks that the Fed should be working on a strategy for tightening.

“If they did it tomorrow, yes it would be damaging because no one expects it. It would be a real shock. You do not want to shock the economy in this way by any means. Don’t think I’m saying they could change the funds rate tomorrow,” he told Marketwatch early in June. “I’m saying if they had a strategy in place that would have seen interest rates moving up in 2011 or 2012, but not a lot, then I think things would be working better. I think it’s quite likely the economy would be doing better. I don’t think all of these things helped the economy.”

Most market watchers think that interest rates will rise in 2014 – because they are, perhaps, artificially low now and in any case can hardly fall any further. In that scenario, here are some tips for positioning your portfolio.

  • Consider holding longer bonds to maturity: Long-term bonds will lose more value than others if interest rates head up, but you only realize these losses if you sell before they mature. Meanwhile collect the interest which, even at today’s low rates, is much higher than what you’d get from shorter-term bonds.
  • For capital preservation, switch to shorter-term bond funds: Long-term bond funds will likely lose value if interest rates head up; therefore if you invest in bonds via funds, you may wish to shift to shorter duration vehicles. Short duration funds won’t provide as much income, but they won’t suffer the same losses as long-term funds as rates rise.
  • Think about dividends: High dividend stocks like utilities, telecoms and REITs can provide you with income, while also enabling you to benefit from some of the growth potential of stocks.
  • Diversify into real assets: Higher interest rates are often accompanied by higher inflation, so you may wish to diversify into assets that hedge against inflation – like real estate, commodities, art and collectibles and precious metal.
  • Don’t panic: Rising rates affect the value of bond portfolios – but they also create more income. Make sure you understand the trade-offs between principal value and income, and that you are appropriately positioned given your specific situation. Then you can ride out any periods of volatility with the confidence that you are investing prudently.