As Markets Face Rising Rates, Rebalancing Gets Tougher

It’s the simple “tire rotation” of personal finance. But a timely rebalance could avert losses when rates rise.

It’s the simple “tire rotation” of personal finance. But a timely rebalance could avert losses when rates rise

[Read: In Search for Yield Interest Rises for Floating Rate Funds.]

People who like to put cash into set-it-and-forget-it funds, such as target-date or balanced funds, could also be facing tough times. Bond funds are especially challenged in times of rising rates because they are not set up as "hold-to-maturity" investments. With an individual bond, holding it and getting interest payments until it matures is the only guarantee in the volatile debt market. Bond funds, meanwhile, need to be active, buying and selling to meet redemptions and remain fully invested, so their net asset value reflects all the market volatility.

There will be disappointment for anyone looking for guaranteed yield that will rise with interest rate increases and also protect your initial investment. Some debt investments, like floating rate notes, cover those needs but come with increased credit risk. And most individual investors simply don't have the tools to navigate that environment.

"There is no security that does that," says Aaron Izenstark, co-founder of Iron Financial, an investment firm specializing in alternative investments. "It's something you need help with. The strategy of a manager with a history of managing bonds is what you need in this market if you want income that avoids credit risk. But it is not possible for the individual investor to do that."

Another part of the rebalancing act is resetting expectations. In a rising rate environment the temptation to "chase yield" will lead some astray. For those who never equated bonds with risk, it's time to consider the downside. That corporate bond maturing in five years might be paying reasonable 3 percent yield – but is there credit risk or chance of an untimely recall? Are you set to hold it to maturity even if its market value plunges as rates rise.

"Americans are challenged at building wealth not because they are not making money," says Bayer, of Up Capital Management, "but because they are not good at assessing their risk tolerance and their expectations when they invest."