The Federal Reserve is finally recognizing just how entrenched inflation has become and looks like it might actually take some serious steps to at least start to address it. Key among those steps is raising interest rates.
Interest rates have been in a downward trend for around 40 years -- since the last time inflation spiked this high -- which makes a rising rates environment something many investors have not experienced. The investing roadmap is a little bit different when interest rates are going up, so knowing how to invest when interest rates rise is a skill that it makes sense to learn. These five strategies can help you navigate what could otherwise be a rocky patch in the market.
No. 1: Get your own balance sheet under control
Rising interest rates mean that the cost of being in debt will increase. If you have variable-rate debts or debts that you will need to borrow more to pay off when they mature, now is a great time to figure out how to pay them off or lock in fixed rates for them. The higher rates rise, the more expensive variable-rate debts will become, and the more expensive it will be to take out new fixed-rate loans, as well.
By getting your debts paid off or refinanced while rates are still fairly low, you can keep control of more of your income and cash flow. That is an important part of being able to assure that you have money available to invest in the first place.
No. 2: Keep your bond duration fairly short
If your financial allocation plan calls for you to own bonds, then in a rising rate environment, you'll want to make sure the bonds you own are fairly short duration ones. This is because the longer a bond's duration, the farther it will fall when interest rates rise.
If your intent is to keep your bonds until they mature, your bonds' cash flows won't change just because interest rates rise. If you use your bonds as portfolio ballast or plan to sell them before maturity, however, recognize that bonds with low coupons and long times until they mature can fall quite far as rates rise. Those are the types of bonds that generally have longer durations and thus are more affected by rising interest rates.
No. 3: Look out for your stocks' balance sheets
The same risks that affect your ability to pay your debts when interest rise also affect the companies you are invested in. As rates rise, their variable rate debt gets more expensive immediately and their fixed-rated debt gets more expensive if they need to refinance it as it matures.
That's important to recognize, since much of corporate debt is structured as bonds where the company pays interest only until they are required to pay the principal in full when the debt matures. As a result, you'll want to pay attention to both their debt levels and their debt maturity schedules -- both of which are often noted in a company's annual reports.
You'll want to make sure that the company still looks capable of servicing its debt from its cash flow even as those debts roll over at higher rates, requiring larger interest payments. If the debt market worries that a company can't make those higher payments, it could force a company into bankruptcy by making it impossible for it to borrow new money. That sort of action could drive its stock all the way down to $0.
No. 4: Seek out businesses with pricing power
As rates rise, businesses with debt will generally see their margins squeezed by those higher debt servicing costs. Those with the ability to pass on those higher costs to their customers via higher prices are more likely able to make it through than those that do not.
Given recent inflation, you might be able to get some perspective on how strong a company's pricing power is by listening to its earnings conference calls. If you hear comments like "volumes remained strong even as we priced to recover commodity pressures," then it's a pretty good sign that the company has at least some measure of pricing power.
No. 5: Focus on the value of the companies you own
Investors generally want to get the best risk-adjusted returns that they can for the money they are putting at risk in the market. As interest rates rise, the future potential returns they can get on lower-risk investments like bonds improve, thus making higher-risk investments like stocks that much less attractive. That's a key reason why the market has been dropping recently as the Federal Reserve talks up the likelihood of more aggressively raising interest rates.
Within that framework, companies that already look fairly valued to downright cheap when compared to their legitimate cash-generating potential may have that much less far to fall as rates rise. After all, the cheaper a company's value, the more of its market price depends on its already proven results rather than its potential for rapid future growth. That makes it easier for investors to see a quick path to operational-driven returns, which can help support those companies' share prices.
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Article initially appeared on motleyfool.com
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