As the S&P 500 crosses the 2,000 mark, unemployment continues to get closer to the six percent level, and the rate of economic growth accelerates, pressure seems to be building for some type of Fed funds rate increase within the next six months.
Continue Reading Below
Regardless if the first hike comes in a month or more than a year from now, the more important question to ask is once initiated how quickly will the rise be and to what level will it top-off?'
Given the Fed's record to date, it's plausible that a hike would be very gradual and stop in the two percent to 2.5 percent range. If this proves to be correct an investor should consider making these moves:
Related Link: Is It Time To Sell Out Of Longer Term Municipal Bonds?
Leave Some Exposure To Long Maturity Bonds
This might seem somewhat counterintuitive, as many times in the past an automatic portfolio move would have been to cut all exposure to long term bonds ahead of rate hike cycle. However, if the final destination' for the rate is two percent to 2.5 percent and it will take a couple years to get there, this allocation is prudent.
While some selective trimming could still make sense, long term rates most likely will be low for a very long time making long bonds preferable over short. In addition, the Fed rate hikes will tend to directly affect short and intermediate bonds more, making these a little more vulnerable on a relative basis to the yield they offer.
Limit Or Trim Exposure To Short/Intermediate Term Bonds
Even though these bonds seldom hurt an investor to any large degree, at this point they most likely offer nominal or even slightly negative returns for the next couple years.
ETFs in this space include iShares 3-7 Year Treasury Fund (NYSE:IEI) and iShares 1-3 Year Credit Fund (NYSE:CSJ). The yields on these bonds are one percent to two percent or less, and once to a two year bond they slip to 0.5 percent per year. These ultra-low current yields (especially in the three year or shorter range) and the likelihood of rising short term rates over the next two years combine to make any material exposure to this section of the bond market unadvisable.
The rising Fed fund rate will tend to affect these bonds more, and that along with paltry current yields will most likely result in near zero returns for the next couple of years. Investors would most likely be better off in long term bonds where the rate increase will have a muted affect and there is more current yield to be had.
Trim Real Estate
Real estate has had a great run in 2014 after a lackluster 2013. The REIT index (represented by Vangaurd's REIT Fund (NYSE:VNQ), is up almost 20 percent! This gain is mostly due to this year's decrease in interest rates. 2013 exposed the real estate sector as particularly vulnerable to interest rate increases.
The combination of historically low current yields (around 3.5 percent), high valuation, and the likelihood of rising interest rates over the next few years makes this asset class particularly exposed. Investors would be wise to trim, take profits, and redeploy elsewhere.
Trim Interest Rate Sensitive Equities; Redeploy To Select Cyclical Sectors And Emerging Markets
Interest rate sensitive stocks like high dividend payers and especially utilities have also run nicely in 2014, and with valuations stretched (especially on the utility shares) investors should consider taking some profits.
Like real estate, these stocks proved sensitive to interest rate rises in 2013, so if interest rates will be rising (making the yields on these investments less attractive) investors should trim before the first hikes. One example for a trim would be Sector SPDR Utility Fund (NYSE:XLU).
Other areas that might be worthy for a deployment of assets would be technology, such as the SPDR Technology Fund (NYSE:XLK) and emerging markets, such as the Vanguard Emerging Market Index Fund (NYSE:VWO).
Eric Mancini is the Director of Investment Research at Traphagen Financial Group (www.tfgllc.com), an independent investment advisory firm located in northern New Jersey.
2014 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.