This article was published in the August issue of Money magazine.
Whenever interest rates jump as sharply as they have recently, investors get rattled. But rising rates don't have to upend stocks as long as you know why yields are surging and how to react.
Some investors fear a replay of 1994, when the Federal Reserve hiked short-term rates six times to combat inflation that was already nearing the key 3% level. That pushed up yields on 10-year Treasuries and sent many stocks tumbling.
Consumer prices today, though, are up only around 1%. Rates are rising instead on fears that the economy is finally strong enough that the Fed can start cutting back on its bond-buying program. Even if that's true, the central bank is a long way from actually lifting short rates. So longer-term bond yields may not soar as much as they did 20 years ago.
This means typical rising-rate plays such as energy stocks may not be the best bet. Think counter-intuitively and focus on growth.
Have faith in financials
While banks could get hit if bond yields climb further -- since demand for borrowing would slow -- other financial companies, such as Charles Schwab (SCHW) and American Express (AXP), stand to benefit.
Schwab, whose earnings are already growing 20% annually, should enjoy greater profits from its money-market mutual funds if near-zero cash yields rise, says Jim Barksdale, president of Equity Investment Corp., which owns both stocks. And American Express could generate higher monthly credit card revenue if rates rise modestly.
Keep riding the housing boom
Don't assume that rising rates will kill the real estate recovery, says Michael Sansoterra, manager of Ridge Worth Large Cap Growth. Mortgage rates are still historically cheap, and an improving economy shouldn't hurt demand for homes.
Among the stocks Sansoterra owns are the homebuilder D.R. Horton (DHI) and Genworth Financial (GNW), which sells mortgage insurance and annuities. Despite posting big gains, both trade at reasonable valuations.
Don't forget dividends
As rates have risen, some income investments that are traditionally viewed as bond alternatives -- such as utility stocks -- have taken a hit.
But Jim Russell, senior equity strategist at U.S. Bank Wealth Management, says, "It would take a really persistent rise in rates before high-dividend-yield stocks lose their attractiveness over bonds." This is especially true of fiscally strong firms that can boost payouts.
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