Protecting Your Portfolio from Rising Interest Rates

Of course, you shouldn't overhaul your entire portfolio in a frantic attempt to keep up with short-term market trends. But if your investment plan didn't already take into account the possibility of rising rates, there are some steps you can still take to minimize the damage.

Action Plan: Protecting Your Portfolio
1) First, you'll need to get a handle on how sensitive to interest rates your portfolio really is. For fixed-income mutual funds, make sure to check the portfolio's duration. Duration provides a more accurate description of a bond's true interest-rate sensitivity than maturity does because duration takes into consideration all mortgage prepayments, puts, and adjustable coupons. To check a fund's duration, enter the ticker and then click on Portfolio on the left side of the Fund Report page. You'll see the fund's duration listed under Style Box Details near the top of the page.

To minimize interest-rate risk, emphasize funds with short- or intermediate-term durations. Morningstar classifies funds with an average duration of less than 3.5 years as short-term, while those with durations greater than or equal to 3.5 years but less than or equal to 6.0 years are categorized as intermediate.

2) It's also worth checking the interest-rate sensitivity of your individual bond holdings. While you may not be overly concerned about shorter-term volatility in a bond's market price if you plan to hold it until its maturity date, it's still worth knowing how much its price could drop if interest rates rise. In general, a bond will be more sensitive to rising rates if it has a longer term to maturity, fewer call provisions, high credit quality, and lower coupons.

If you're willing to do some math, you can calculate a bond's duration on your own. (For the details, you can read the tutorial from this outside site.) Or, your brokerage firm or bank may be able to give you details on duration for your bond holdings.

3) Some stocks can also be sensitive to rising interest rates. When interest rates spiked in 1994, financial services stocks lagged the market by more than four percentage points, on average. To check your portfolio's sector exposure, enter your holdings through Morningstar.com's Instant X-Ray tool. Compare the Financial Services percentage to the number shown for the market benchmark to see if you're overweighted in this sector.  

Keep in mind that it's not a given that financial stocks will lag when interest rates rise, though: Regional banks have held up fairly well relative to the broader market thanks to their diversified revenue streams. Other financial services issues--such as money center banks, insurance stocks, and brokerage firms--may be more vulnerable. 

4) Check your portfolio's asset allocation to make sure it fits your long-term goals. Because even the pros haven't been able to predict the direction of interest-rate moves consistently, your time horizon and tolerance for risk should ultimately determine the fixed-income allocation for your portfolio. Morningstar.com's  Asset Allocator tool (one of the benefits of Premium Membership) can help you set the most appropriate allocation for your needs.

Learn More: Readings
Rising Interest Rates and Bank Earnings
by Jim Callahan

What If Interest Rates Rise?
by Brian Lund

When Rising Rates Benefit Bank Stocks
by Craig Woker

Three Funds that Can Weather Rising Rates
by Paul Herbert

Bond Funds Brace for Rising Rates
by Scott Berry