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Consumers Pay Both Ways

Borrowing rates have jumped but savings rates remain paltry.
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hasn't even raised interest rates yet, but weeks of anticipation are already giving both borrowers and investors a bad case of the rate-hike blues.

It seems the economy's at a turning point -- moving from historic 46-year interest-rate lows to a period of unknown higher rates. The question is: how to prepare?

We'll take a quick look at how rates have already changed for consumers. And then share what financial advisers are telling investors to do now.

Rates have already risen for borrowers (see chart). While the Federal Reserve controls short-term interest rates through the fed funds rate (the cost of banks borrowing from one another), currently at 1%, long-term rates are controlled by the bond market, which tries to anticipate inflation.

Thus auto loans rates have risen less sharply than mortgage rates. A 48-month auto loan, according to, has risen from 5.26% to 5.61%, up 6.6% in the last three months.

A 30-year, fixed-rate mortgage, however, has climbed from 5.26% to 6.08% in the same period, an increase of 15.5%.

Financial advisers recommend that anyone wanting a fixed-rate mortgage should try to lock in now, because it is difficult to predict what the bond market will do in the coming months. And a 6.08% loan is still close to historic mortgage rate lows.

While rates for borrowers have risen noticeably, those for savers are still paltry, awaiting an actual increase in the prime rate. The average money market fund, according to, is 1.36%, compared to 1.34% three months ago, and a one-year CD, or certificate of deposit, is 1.75% compared to 1.69%.

For those willing to buy and hold bonds, rates are becoming more attractive. The yield on the five-year Treasury bond, for example, has risen from 3.25% to 3.93% in the past three months.

But as yields (or rates) rise, prices -- which move in the opposite direction -- drop. So investors needing to cash out bond funds or individual bonds before maturity can suffer a loss of principal, sometimes sizable. Taxable bond mutual funds, currently down 3.42%, are on track for their worst quarter since 1987, according to Lipper.

Stock market investors also face a quandary. When interest rates start to rise, stock prices often decline. As companies suffer the effects of inflation, higher borrowing costs and shrinking profits, they eventually lose investors to higher-yielding fixed-income investments. The

S&P 500

, for example, has lost more than 4% of its value in the past three months.

So what are investors to do? Advisers seem to have three different approaches:

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Take your cards off the table

Robert Gerstemeier, a CFP and MBA with the Gerstemeier Financial Group of Naperville, Ill., has moved all his clients in bonds with very short durations or terms, in preparation for the dramatic change he sees in the bond market.

"I'm telling them it isn't safe to go back into the water yet, so let's hang out on the beach for awhile," he said. "There is a lot of pain yet to come for longer-term bond investments and I'm not comfortable going back in for awhile."

Fine-tune your bond holdings

"We're kind of in a fix. There is no good answer," said Warren F. McIntyre, a fee-only CFP with VisionQuest Financial Planning LLC in Troy, Mich., who advises clients but does not manage their money.

He said every investor's portfolio should have about 20% in bonds, but this is not a good time to buy or hold them. His goal, then, is to reduce the average term of bonds held and diversify the types of bond investments.

One possibility, McIntyre said, is to trade off interest rate risk - the risk that as rates move higher, bond principal will fall - for credit risk, the risk of a borrower's inability to repay the bond.

With the economy presumably improving, corporate bonds and high-yield bonds that have higher credit risks might be a source of good income. (The market has already priced them higher, so there's not much room to gain value in their price.)

Another alternative is taking some currency risk using mutual funds to buy international bonds. He recommended the




mutual fund families.

McIntyre also suggests using TIPS, U.S. Treasury Inflation-Protected Securities (, whose yields have built-in, guaranteed adjustments for changes in the rate of inflation.

Adopt a Zen-like attitude and practice asset allocation

Bedda Emous, a fee-only CFP with Fiduciary Solutions in North Andover, Mass., noted that the immediate spike in bond and mortgage rates shows how efficient the market is.

"What perfect evidence that market timing really does not work and what perfect evidence of rearview vision," she said. "Because markets are efficient, it is too late for investors to react to interest rate increases." (Market timing is the practice of deciding when to buy and sell securities because of economic or technical factors rather than buying and holding them for the long term.)

Emous has her clients invest using an asset-allocation model based on quantitative analysis (see chart below on her model portfolio). This investment philosophy, based on the work of Nobel prize-winning economists, says you should invest in a variety of asset classes because you never know when one is suddenly going to take off -- and investors need to own it to enjoy the returns.

"It's the air-mattress effect," she said. "One sector goes up, the other goes down. My clients see ongoing, steady returns."

For Long-Term Investors
Building a portfolio to minimize interest-rate damage

Source: Bedda Emous, CFP, Fiduciary Solutions, LLC

Michael Ancona, a chartered financial adviser with Ancona Financial Advisors in Scotch Plains, N.J., noted that the seeming bleakness of this market is nothing new.

In the first half of 2003, financial prognosticators were wringing their hands about the start of the war in Iraq, the SARS epidemic, the weak dollar and investment house scandals. And the outcome?

"Last year was one of the best in history for the equity market," Ancona said. "It was hard to earn less than 25% returns. The point is, capitalism works. Over time, the markets will reward investments with a market return."