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Rising Bond Yields May Shake Up Equity Portfolios

Although some sectors will feel the pinch from a rapid rise in interest rates, others may do just fine.

With interest rates on the rise, now may be a good time to modify your portfolio.

Higher rates typically translate into lower price-to-earnings ratios on Wall Street. But that's not always the case. Although some sectors will certainly feel the pinch from a rapid rise in bond yields, analysts say that other groups of stocks should hold up just fine.

The yield on the 10-year Treasury surged Thursday as investors began to sense that the economy is turning around. Investors have sold bonds because a stronger economy often leads to inflation, which eats away at returns on fixed-income securities. Since hitting a low on June 13, the yield on the 10-year note has climbed about 135 basis points to a current rate of 4.46%. Bond prices and yields move in opposite directions.

"The end of the bull market in bonds is a momentous event that has a number of implications for the equity market," said Francois Trahan, chief investment strategist at Bear Stearns. "A trough in bond yields will likely mark the end of the outperformance line for a number of segments, mainly the interest rate sensitive ones, and the rising of the dawn for others, mostly cyclicals."

Historically, Trahan said, technology, energy, materials, industrials and telecom stocks have acted reasonably well in periods of rising rates, while financials, consumer discretionary, utilities, consumer staples and health care tend to perform poorly.

"To the extent that the rise in rates signals a somewhat firming economy, I think there will be a rotation out of some of the more defensive names like consumer staples and into more cyclical companies like the materials and industrials," said Brett Gallagher, chief investment strategist at Julius Baer.

As the economy improves and demand picks up, firms like

Caterpillar

(CAT) - Get Report

and

DuPont

(DD) - Get Report

should be able to raise prices, analysts said. But stocks that investors flocked to for protection during the downturn, like health care and consumer products, will likely be shunned.

"Despite the investment community's overwhelming desire to own health care stocks, steep yield curves do not favor them once economic activity ignites," said Tobias Levkovich, chief investment strategist at Smith Barney. "This may simply be the result of the relative earnings growth within more cyclical sectors overpowering those with more defensive characteristics."

Analysts also caution investors to steer clear of utility stocks, which are big borrowers and typically see earnings shrink in periods of rising interest rates. When firms borrow money from investors, they typically pay a higher yield than the 10-year Treasury because corporate bonds carry more risk. If the Treasury rate increases, corporate borrowing costs also rise and that can crimp profits.

Within the financial sector, residential mortgage lenders like

Washington Mutual

(WM) - Get Report

and

Countrywide Credit

(CFC)

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are at risk, as business will probably slow amid weak demand. Mortgage rates shot up to 6.14% in the latest week, from an average of 5.21% in mid-June, according to Freddie Mac.

Stanley Nabi, managing director at Credit Suisse First Boston, said financial firms that offer commercial and industrial loans are in a better position, however.

"When there's a diminished amount of competition for funds, banks have to lend at low rates, but when demand picks up, they have flexibility to raise their rates," he said. "Credit card companies typically tend to benefit from rising interest rates." Others note that large banks and diversified financials could conceivably do well as capital markets improve.

Meanwhile, in the consumer discretionary sector, some analysts warn that housing stocks could see further losses because demand for new homes is expected to slow as rates move higher. But Levkovich said the tight supply of homes "and the availability of attractive adjustable-rate mortgages could alleviate such concerns." He actually recommends buying

Lennar

(LEN) - Get Report

,

Pulte

(PHM) - Get Report

and

Beazer Homes

(BZH) - Get Report

on weakness.

As for the direction of technology stocks, analysts are equally divided. Credit Suisse's Nabi notes that many technology companies have very little debt and therefore aren't always negatively affected by higher rates.

"A company like

Microsoft

(MSFT) - Get Report

, which has $46 billion in cash, will be helped by rising interest rates because they'll be able to earn a higher rate on that money," he said, adding that

Cisco

(CSCO) - Get Report

also has "a lot of cash and no debt."

But Gallagher isn't so sure. "Higher rates could discourage capital investment but a stronger economy could help out. It's a tricky balance, and I'm not sure how it'll shake out," he said.