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."
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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."