How to Profit From Rising Interest Rates

By Mark Cussen Markets Fool.com

The Federal Reserve Bank finally raised interest rates by a quarter of a percentage in December, and it promises that more rate increases will happen in the coming months. A rising-interest rate environment can provide some profitable opportunities for savvy investors who have been sitting on cash instead of investing their money at historically low rates. Here are some ways to boost your returns in a period of rising interest rates.

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Create a bond ladder

This is not a good time to lock money into long-term fixed-income instruments such as Treasury bonds. Build a portfolio of short-term notes that will periodically come due, perhaps a month after each meeting of the Federal Reserve.You can most easily do this with CDs, commercial paper, or Treasury securities. Simply buy a group of bonds or CDs that have maturities that are staggered in 90-day or 180-day increments, so that the first one will mature in 90 or 180 days, and subsequent ones will mature every 90 to 180 days thereafter. This will provide you with new money after each possible rate increase so that you can reinvest your bonds or CDs at a higher interest rate from new issues that become available.

Invest in Treasury Inflation Protected Securities (TIPS)

These special bonds are backed by the full faith and credit of the U.S. government. They pay a fixed rate of interest twice each year, and the principal in them is also adjusted for on a semiannual basis. The government makes this adjustment based upon changes in the Consumer Price Index (CPI), which is widely considered the best indicator of inflation. The principal in these bonds can be adjusted up or down, but you are guaranteed to receive at least the return of your full principal no matter what. These bonds are attractive to investors in a low-interest rate environment, as they will most likely rise in value with inflation. The Treasury has instructions on how and where you can purchase TIPS.As with other types of Treasury securities, the interest paid on these bonds is exempt from state and local taxation.

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Invest in banks and financial services companies

The financial industry always profits when interest rates start to rise, as this means they can charge higher interest rates on loans and other financial products. Of course, the interest rates they pay will rise as well, but banks can still make a profit from the spread on holding the securities of other banks. When the Federal Reserve raised the Federal Funds rate by 1% from 2003 to 2004, the major online brokerage firms netted an increase of 38% in their interest income, and their operating margins consequently rose by over 10%. Focusing on financial companies that have less debt than their peers may boost your returns somewhat, as these companies will not be as adversely affected by rising rates.

Realize capital losses from your bonds and bond funds

Bond prices will start to fall in the secondary market when interest rates start to rise. This may offer a good opportunity to realize some capital losses in your fixed-income portfolio. These losses can be netted against any taxable capital gains that you realize during the year and also against other forms of income within certain limits, which will lower your overall tax bill. Just be sure to wait at least 30 days before you buy your bonds or bond funds back so that you can declare a capital loss on the sale on your tax return and satisfy the IRS wash sale rule. (This rule states that taxpayers must wait for at least 30 days before buying back a losing holding if they want to report a capital loss from the sale.)

These are just some of the many moves you could make to better position yourself to profit in a rising interest rate environment. And remember that the prospect of rising interest rates alone should not dictate your investment decisions -- nor should any other economic indicator.

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