Playing Defense with the Fed

At this point it's almost a guarantee that interest rates are going to rise. The Federal Reserve has kept its benchmark rate at an historic low since December 2008 in an effort to revive the economy, and hopefully prevent a nasty depression. Low interest rates discourages saving and increases the likely hood that business and consumers will borrow and spend, stimulating the economy. Combining this with the billions in stimulus measures and tax credits, the fed has managed to slowly right the ship. But no good deed goes unpunished and all this excess liquidity and low rates could help push the economy into an inflationary environment.

"We know that Zero is Nonsustainable"

The real question for investors isn't if the fed will raise rates, but when. Inflation is becoming a concern as the recovering global economy has recently put the spurs to assets of all types. Some analysts believe that could come as early as this spring with severe tightening coming by the end of the year. Others are predicting that rate increases until later in 2011. Either way, investors should be proactive with their portfolios as higher interest rates can wreak havoc on allsorts of investments.

Preparing for the Inevitable  

While each interest rate cycle are complex and bring their own identities to the markets, certain assumptions still hold true. We can use history as a guide and gradually shift our portfolios to take advantage of the newly rising rates whenever they might occur. Higher rates are terrible for fixed income investments. Their prices fall as investors can simply buy new cheaper bonds with higher yields. Investors can stay in short term bond funds such as iShares Barclays Short Treasury Bond (NYSE: SHV) or iShares Barclays 1-3 Year Credit Bond (NYSE: CSJ). These funds are able to roll over their holdings quicker and pick up the rate increases.

Investors wanting to make a bolder statement on bond prices can short the long bond. Either directly by shorting the iShares Barclays 20+ Year Treasury Bond (NYSE: TLT) or by purchasing the inverse ProShares UltraShort 20+ Year Treasury (NYSE: TBT), investors can profit with respect to falling prices. Long time-lined bonds are some of the harder hit during periods of rising interest rates.

Investors may want to place their bets with companies that can pass on the higher cost of borrowing onto consumers. Consumer staples companies such as Coca-Cola (NYSE: KO) or Procter & Gamble (NYSE: PG) can reduce product sizes or raise prices without really any loss in business. The Consumer Staples Select Sector SPDR (NYSE: XLP) represents a diverse basket of stocks within the sector. These companies also reward shareholders with a healthy dividend yields.

An allocation to Treasury Inflation Protective Security (TIPS) bonds make sense as inflationary pressures are one of the chief concerns with fed's decision to raise rates in the first place. The iShares Barclays TIPS Bond (NYSE: TIP) distribution payments will rise as interest rates increase.Finally, times of rising rates should boost the U.S. dollar. This helps attract foreign capital to dollar denominated assets such as government bonds, but also hurts many of the commodities priced in greenbacks such as oil. While, I wouldn't give up on my natural resource holdings just yet, as longer term demand from growing emerging economies will continue to push these asset prices up, trimming some allocation in the sector may make sense.

Playing Defense

It's true that the fed can't keep interest rates at zero for ever and that rates in inevitable rise, the real question for investors is when. Over a year has past and the day is ever inching closer to when they will ultimately begin tightening. Investors may want to begin thinking about strategies to help protect their portfolios in such an environment. The proceeding stocks and exchange traded funds are great ways to play defense against such an occurrence.