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Preparing Equity Portfolios For Rising Rates

August 19th, 2013

percent rateEven if the Federal Reserve (Fed) begins tapering its asset purchases next month, I don’t believe a bond market meltdown is imminent thanks to the many factors helping to keep a lid on interest rates.

Still, as I write in my new Market Perspectives piece, “Investing in a Rising Rate Environment”, the yield on the 10-year Treasury is up about 100 basis points from last summer’s all-time low and yields are likely to continue to moderately rise over the next two to three years.

This begs the question: How should investors adjust their portfolios for slowly rising ratesProbably the simplest prescription may be to shift the portfolio mix toward stocks, which historically have improved portfolio performance during periods of rising rates, as my colleague Daniel Morillo recently pointed out, while considering the increased risk of such a change.

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And within a larger equity allocation, here are three more specific ideas to consider.

1. Lessen exposure to bond market proxies like utility companies.These segments have historically responded poorly to rising real rates. For instance, when real rates rise, the relative valuation of utility companies, as measured by sector’s price-to-earnings ratio relative to the broader market, compresses as investors become less willing to pay up for each dollar of earnings.[1] This suggests that if utility valuations are high, as they are today, the sector could underperform in a rising rate environment.

2. Consider the US technology sector, which generally has had a tendency to perform well, relative to the broader market, when real rates are rising. This is partly because technology companies carry little debt so they are less vulnerable to margin compression from rising rates. In addition, as I write in my Market Perspectives piece, real rates generally rise in the context of a strengthening economy, a regime favorable to cyclical companies like tech firms. The US technology sector is accessible through funds such as the iShares U.S. Technology ETF (NYSEARCA:IYW).

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