- Rising interest rates are a potential headwind even as the economy expands.
- Here are some ways to prepare your portfolio for the changes ahead.
Investors may be rattled heading into the new year, and rightfully so.
Even as the omicron Covid variant drives a new wave of infections, the Federal Reserve's easy money policies are nearing an end.
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For months, a variety of inflation reports reached their highest levels in decades. The Consumer Price Index, which measures the cost of a wide-ranging basket of goods and services, surged 6.8% year over year, the fastest rate since June 1982.
In response, the central bank signaled it will make aggressive policy moves with Fed officials seeing as many as three rate hikes this year, two more next year and another two in 2024.
"The writing is on the wall that interest rates are poised to rise in 2022, but don't let that obscure the bigger picture, which is that the economy is expanding, unemployment is falling and corporate profits are expected to grow," said Greg McBride, chief financial analyst at Bankrate.com.
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"People are terrified because they see interest rates are going to go up," added Daniel Milan, managing partner of Cornerstone Financial Services in Southfield, Michigan. "But, from an investment standpoint, interest rates go up when the economy is typically going well."
"People are spending," he added. "If you look at it from a different lens, this means some positive things are happening."
To take advantage of the current climate, Milan advises clients to make four key changes to their portfolios. Here are his top recommendations:
Avoid longer-term fixed income assets: Generally, Treasury bonds lose value over time if the interest they earn is below the rate of inflation. Currently, the bellwether 10-year note is yielding about 1.62%.
"If you are going to have bonds in your portfolio, we recommend short-term bond funds until interest rates go up," Milan said. "They are going to be less risky in a rising rate environment."
Although short-term bond funds are less sensitive to rate increases, they also provide less income earning potential.
Still, they'll add some stability when equity markets get rocky, McBride said. "Even if the market does well this year, it's likely to be a bumpy ride along the way.
"It's during that bumpy ride, you'll be glad to have some money in bonds," he said.
Find a floating rate: Bond funds that adjust for inflation are another way to mitigate risk.
For investors who are looking to section off a portion of their portfolio — say, one to three years' worth of retirement income — into a less volatile investment that will keep pace with current inflation, a floating rate exchange-traded bond fund may be appropriate, said Katelyn Murray, a certified financial planner at Kendall Capital in Rockville, Maryland.
"These ETFs are conservative like a bond, trade like a stock and diversify like a mutual fund," she said.
Milan recommends floating rate bond ETFs like the iShares Floating Rate or Market Vectors Investment Grade Floating Rate, which include investment-grade corporate bonds and are less exposed to interest-rate risk over time.
However, "you don't want to be overly conservative and miss out on the appreciation you can get in the equity market," Murray added. "You need long-term growth, as well."
Seek out stocks with dividend growth: To that end, companies that are well poised to weather higher prices and have a track record of consistent dividend payouts are also good assets to own as interest rates rise.
Milan recommends large-cap staples, like Home Depot, Lowe's and PepsiCo, for example, which have a history of increasing dividends year over year.
"That is both a protection against inflation and offers a yield that bonds currently do not," he said.
Focus on the financial sector. Financial stocks generally benefit from a strong economy and higher rates since banks can charge borrowers more, while still paying depositors less.
"As rates go up, the financial sector performs pretty well," Milan said, particularly stocks such as PNC Financial Services or ETFs like First Trust, he added. (Experts say international stocks, utilities, health care, consumer staples and real estate investment trusts could also outperform the broader market in 2022.)
"Does that mean you radically change your approach? Not necessarily," said CFP Douglas Boneparth, president of Bone Fide Wealth in New York.
"Financial services are generally attractive but there's danger in always saying this will happen," he cautioned.
"If rising rates don't materialize in the way you thought, you may find yourself underperforming."