Five Strategies for a Rising Rate Environment

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The Federal Reserve can't accommodate forever, and the global stimulus effort will likely lead to inflation. Our growing indebtedness can only result in increased borrowing costs.

That much we know.  What we don't know is when and how quickly interest rates will rise.

Consider the differing opinions of two of the world's largest investment banks. Goldman Sachs doesn't foresee a rate change in the U.S. until 2012 and is forecasting a 3.25 percent 10-year Treasury yield at the end of this year. Compare that to the 4.5 percent 10-year Treasury yield that Morgan Stanley is forecasting and you have two firms disagreeing not only about the timing, speed and shape of the yield curve, but also on the fate of the U.S. economy.

So, what are we to do? On the timing front, it's anybody's guess. Up until the end of April, Morgan Stanley was anticipating a rate hike in September, but it has now pushed its prediction back to early 2011. Morgan Stanley had also forecasted an end-of-year Treasury yield of 5.5 percent in April, which it dropped an entire percentage point when Europe's sovereign debt issues and contagion fears came to a head.

On the investment front, advisors have at their disposal the usual technique of shortening bond maturities to dampen losses caused by increasing interest rates. But your investment strategy shouldn't end there. We propose five additional strategies to protect further against rising rates and inflation – strategies that also diversify and improve the strategic positioning of a portfolio.

1. Ultra-Short Bonds: Lengthen cash and shorten short-bonds

Many advisors are used to short-duration bond funds that target a one- to three-year duration, but in our experience they often steer clear of ultra-short strategies. Ultra-short bond funds target a much shorter duration, typically between 0.5 and 1.5. (The "ultra" in the strategy's name doesn't refer to leverage.)

Ultra-short bonds have two main advantages: diversification and yield.

An ultra-short strategy diversifies and can even fine-tune your duration target. An advisor using only a short bond strategy and a total bond market strategy is limited in his or her duration range. For example, the Vanguard Short-Term Bond ETF (BSV) has a duration of 2.6, and the Vanguard Total Bond Index ETF (BND) has a duration of 4.5, according to Morningstar, Inc. (as of 4/30/2010). An ultra-short fund would allow an advisor to bring average overall duration down in a more substantial way.

Many ultra-short funds offer a decent yield compared to the near-zero yield you get on most money market funds today. By moving slightly out on the yield curve, you can pick up more than 1.4 percent in yield. Obviously, ultra-short funds are not money market funds, and their prices will fluctuate, so the strategy you select matters greatly.