Investments to watch in a rising-rate environment

People are taking a fresh look at their portfolios these days. Part of it is routine rebalancing for a new year, but part of it is adjusting holdings for a rising-interest-rate environment. That second maneuver can be quite tricky to manage.

After a year of rising interest rates (except for very short-term rates) and strong stock market performance, rebalancing to a fixed target would mean selling stocks and buying bonds. However, buying bonds is one of the worst things you can do in a rising-interest-rate environment.

Before you rebalance your portfolio, it may be wise to revisit your target allocation, keeping in mind that a long era of falling interest rates seems to have ended, and a new era of rising rates may have just begun.

Investments to watch

Here, ranked from best to worst, is a hierarchy of financial choices for a rising-interest-rate environment:
  1. CDs -- given the right terms. You might question why you would want to lock into a CD if rates are going to be rising. There are two reasons: One is that average long-term CD rates are several times higher than savings and money market rates right now. The second is that short-term interest rates are likely to be the last to rise in the current environment, so it may be a while before savings and money market accounts start to respond. What you should look for are longer-term CDs with a significant rate advantage over short-term bank rates, and with relatively mild early withdrawal penalties so you can duck out if rates rise sharply enough.
  2. Savings accounts/money market accounts. These bank rates did not rise last year while bond yields and mortgage rates were rising, and as noted above, they may remain slow to join the trend. Still, they are worth keeping an eye on because once they do start rising, they will give you the maximum flexibility for capturing higher rates. Be sure to compare bank rates before choosing an account, because some banks will join the rising rate trend much sooner and much more decisively than others.
  3. Stocks. Rising rates will hurt stocks from a valuation standpoint, but their earnings would benefit from a stronger economy. So, as long as rates are rising because the economy seems to be improving, stocks remain a decent place to put some of your money.
  4. Real estate. It is a toss-up whether to rank real estate above or below stocks on this list. Higher mortgage rates create a headwind for real estate prices, but in a stronger economy that could be offset by rising demand.
  5. Bonds. Bonds are pretty much nothing but trouble in a rising rate environment -- their prices are inversely related to their yields. Check back on bonds once yields have risen enough to be attractive in their own right.

One thing about a rising rate environment: It can be awfully tough sledding for a while. Short-term assets are starting out at extremely low yields, while long-term assets face a stiffer valuation hurdle as rates rise.