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Market Update

5 Ways to Prepare for Rising Interest Rates

Paying off credit card debt, considering bank stocks, and starting a CD ladder are just a few things investors can do, says John Waggoner.

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Life may be full of uncertainties, but there are a few things you can count on: The sun rising in the east, the swallows returning to Capistrano, and Wile E. Coyote surviving yet another 50-story fall into a canyon.

For investors, matters tend to be a bit murkier. But it's hard to argue that short-term interest rates would go much lower than they are now, because short-term rates rest at zero. What can you do to prepare for a rise in rates? Quite a few things.

Let's start with the basics. The Federal Reserve largely controls short-term interest rates through its powerful Open Market Committee. It lowers its Fed funds rate--a key overnight interbank rate--when inflation is low and the economy needs a boost. It raises the Fed funds rate when inflation exceeds its target and the economy looks overheated.

The Fed last boosted the Fed funds rate in June 2006, and it has kept the rate at near zero since December 2008. Throughout much of this year, Wall Street has been anticipating that the Fed would change course and start to raise interest rates: After all, the unemployment rate has fallen to 5.3% and inflation--minus food and energy--is running at 1.7%, close to the Fed's target of 2%.

You're unlikely to take out an overnight interbank loan any time soon. And the Fed funds rate has little to do with long-term interest rates, which march to the bond market's drummer. Nevertheless, short-term rates do affect your financial life, and Federal Reserve chair Janet Yellen said last week that the Fed would raise short-term rates "later this year." Most variable-rate debt is tied to short-term interest rates, as are most short-term savings vehicles. And the stock market keeps a wary eye on short-term rates as well. How should you prepare?

Pay off credit card debt.
This is a good move in any event. The average credit card charges 15.91% interest, according to Bankrate.com. Being saddled with high-interest debt is like going swimming with barbells.

As bad as current rates are, however, they will only get worse if the Federal Reserve pushes up interest rates in September, as expected. Most credit cards base their rates on the prime rate, which, in turn, is tied closely to the Fed funds rate. When the Fed funds rate rises, the prime does, too. Banks aren't shy about raising rates when the Fed does, and the interest rates on most cards will rise about two minutes after the Fed announcement.

Consider bank stocks.
The Fed rarely increases interest rates once and then stops. Most economists expect a series of rate hikes through 2016. And, as noted above, banks are quick to raise rates on variable-rate loans. They're not so quick, however, to raise rates on deposits, such as certificates of deposit. Loan profits depend on the spread between the cost of a bank's funds--deposits--and the return from its loans. A widening spread means a bump in bank profits, all other things being equal.

Don't expect an explosion in bank stocks after the first rate hike, warns Morningstar analyst Jim Sinegal. "One or two quarter-point moves won't make a huge difference," he says. A favorite bank stock: U.S. Bancorp (USB), says Morningstar senior equity analyst Dan Werner. As of this writing, the stock is about 17% undervalued, he says, and 30% of its deposits pay no interest at all. It also has substantial fee income and a payments processing business that has helped mute the impact of the global decline in yields.

Dust off your money market fund.
Most money funds yield nothing, quite literally. Those that do pay any interest yield very little: On average, 0.02%, or $2 per $10,000 invested. But yields on money funds are closely tied to the Fed funds rate, and as the Fed raises interest rates, the yield on your money fund will rise, too. Granted, you're not going to get wealthy from money funds, but earning something is always better than earning nothing.

You might also consider a bank money market account, which have been consistently paying higher interest rates than money funds. Currently, for example, Ally Bank offers a federally insured money market account yielding 0.99%. The difference between bank money market accounts and money market funds, aside from deposit insurance: Bank money market accounts have administrated rates. They may or may not move in tandem with market rates. Money funds offer market rates, and their yields depend on the direction of the money market.

Start a CD ladder.
Bank deposit rates also track short-term rates fairly closely. But the highest bank rates are typically five-year bank CDs. Buy one now, and you'll lock into those miserable rates for the next five years. But if you create a ladder, you can gradually lock into higher rates.

In a simple ladder, you divide your cash into five parts, and invest in a one-, two-, three-, four-, and five-year CD. When the one-year CD matures, you replace it with a five-year CD--which, presumably, will yield more next year than it does this year.

Eventually, you'll have a portfolio of five-year CDs, one of which matures every year. As rates rise, you'll lock in progressively higher yields. Should rates eventually fall again, you'll still have some (relatively) high-yielding five-year CDs in your portfolio.

Don't sell your stocks.
The old Wall Street adage of "three steps and a stumble" probably doesn't apply now. The rule was that after three Fed rate hikes, the stock market falls. And that's because the first two hikes are generally seen as a sign that the economy is healthy and the demand for loans is rising. By the third hike, however, investors begin to worry that the Fed is trying to slow the economy or send it into recession--and that's when stocks would tumble.

But that adage was formed when the normal Fed funds rate was 3% to 5%. The Fed raised interest rates 17 times from 2003-06, and the stock market didn't crack until October 2007. Although rising rates can affect companies with a great deal of short-term borrowing, most companies that needed to refinance their debt to lower rates have already done so.

Typically, stock investors don't start worrying about short-term interest rates until it's clear that the Fed has raised rates beyond normal and is, in fact, trying to slow the economy. At that point, it's wise to start taking defensive measures. But that point is still a long way off.

The earliest most experts think the Fed will raise interest rates is at its September meeting. But the recent turmoil in Greece and the Chinese stock market is starting to push those prognostications back. "The Fed said in its minutes that it's very worried about those two events, and after reading those notes, maybe a September rate hike won't happen," says Bob Johnson, director of economic analysis at Morningstar.

The last time the Fed started raising rates, it did so after nearly every meeting. But this time around, the pace could be more leisurely. The Fed meets again in September, October, and December. But John Lonski, team managing director of the economics group at Moody's Analytics, points to the futures market as evidence that we probably won't see rate hikes at each meeting. The futures contract for Fed funds indicates a yield of 0.28%, he says, indicating that the pace of Fed rate hikes could be slower than expected. "The market would be surprised if the Fed funds rate were 0.5% in December," Lonski says.

Whatever the pace of Fed hikes, the biggest thing to remember when the Fed raises rates is this: Don't panic. The Fed will have to raise rates sooner or later. "If we have another crisis right now, they can't really lower rates to stimulate the economy," says Johnson. "So, there really is a bias to raising rates." And if short-term rates were to rise to 4%, long-suffering savers could finally make a bit of money on their nest eggs.

John Waggoner is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

John Waggoner does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.