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Should You Fear Higher Interest Rates?

Stocks in this article: WFC^GSPC

NEW YORK (TheStreet) -- How should you allocate your investments when interest rates appear to be heading higher?

The answer in large part depends on your investment horizon. If you are in for the very long term, fluctuation of interest rates may not be very important for your strategy. But over the next couple of years, rising rates may have quite an effect on stock and bond valuations.

Despite the well-publicized rise in long-term interest rates during 2013, as the Federal Reserve prepared to begin tapering its bond purchases, rates are still at low historical levels. The market yield on 10-year U.S. Treasury bonds was 2.65% on Thursday. That's down from 3.04% at the end of last year, but up from 1.89% a year ago. But long-term rates are still expected to head higher, since the Fed plans to end its bond purchases by the end of 2014.

The yield on 5-year Treasury bonds was 1.49% Thursday, down from 1.75% at the end of 2013, but up from 0.77% a year ago.

Meanwhile, the Federal Reserve continues to keep its target short-term federal funds rate in a range of zero to 0.25%, meaning that savers are really taking it on the chin, with banks paying next to nothing on savings accounts and paying very low rates on CDs. The national average interest rate for a 12-month CD is 0.20%, according to BankingMyWay, while a 24-month CD pays 0.38% and a 60-month CD pays 0.78%, on average.

So the most conservative savers, with no risk tolerance, are earning very little.

The S&P 500 closed at record high of 1,854.29 Thursday, although the index has risen only slightly this year, following a 30% gain in 2012 and a 13% return during 2011.

In the face of an expected rise in interest rates, many investors may be wondering how they should allocate their retirement savings accounts. Managers of 401k plans tend to recommend diversification, with investments spread over asset classes and stock investments spread over various industries and locations.

Wells Fargo (WFC) manages a group of Advantage Dow Jones Target mutual funds. Each fund is designed for investors seeking to retire at a particular time, with the idea being that the fund's allocation will become more conservative -- that is, more income-oriented -- over time.

For example, the Wells Fargo Advantage Dow Jones Target 2035 Fund is designed for investors planning to work for another 21 years, or thereabouts. The fund's assets are roughly 50% weighted to domestic stocks, 25% in foreign stocks, with the remaining 25% mostly invested in bonds and other income-paying securities.

The fund's stock holdings are spread across various industries, with Financial Services, Technology, Industrials and Consumer Cyclical stocks carrying the greatest weight.

At this stage of the bull market, some investors might fear that the expected rise in interest rates may cause a stock market decline, and may also be nervous about the decline in bond prices always brought about when long-term interest rates rise. All things being equal, prices of bonds go down when interest rates rise, because new bonds are being issued at higher rates. Bonds with similar ratings will see their market prices adjust in such a way to make their current yields match the yields of newly issued bonds.

FM Global Senior Vice President of Investments Paul LaFleche in an interview earlier this week discussed his team's investment philosophy and expectations for rising interest rates, and the possible effect on market performance.

FM Global is a mutually owned property and casualty insurer, primarily focused on insuring commercial property.

All insurance companies manage investment portfolios, trying to achieve solid returns in order to increase their likelihood of making profits even when insurance losses are high.

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