Brace For an Interest Rate Hike

money under a magnifying glass
money under a magnifying glass

By Selena Maranjian,Motley Fool

No one can predict the financial or economic future correctly and consistently. Still, there seems to be a reasonable chance that interest rates may rise soon. Inflation's on the rise, and rate hikes can help keep its effects in check. Unfortunately, they could also knock your portfolio for a loop.

A recent report from the Bureau of Labor Statistics reveals that inflation, as defined by the Consumer Price Index for All Urban Consumers (CPI-U), advanced half a percent in March over February (which also saw a half-percent jump).

We can take comfort in knowing that the index is only up 2.7% over the past 12 months, which nearly matches the historic rate of inflation. Better still, food is only up 2.9%, and electricity has only increased 1%. But gasoline has increased 27.5% over the past year, fuel oil is up 34%, and in the past month alone, food at home has gained 1.1%.

Winners and Losers
Interest rates might stay low, which benefits home buyers and other borrowers, as well as investors in banks and mortgage REITs. Banks enjoy paying modest interest to savers, while charging considerably more to borrowers, so rising rates can cramp their style.

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Weiss Ratings recently found that three-quarters of banks stand to suffer from rising rates, with Bank of America (BAC) units in Oregon, California and Rhode Island among the most vulnerable, and JPMorgan Chase, State Street, and Citigroup's (C) Citibank among those best-positioned for rising rates.

Mortgage REITs, meanwhile, also profit via that spread, ideally borrowing at low rates and then investing in mortgage-backed securities that deliver payouts based on higher rates. Business has been great for such outfits in recent years, making darlings of companies such as Chimera Investment (CIM) and Annaly Capital Management (NLY). Since REITs must pay out most of their income in dividends, this led to hefty, attractive dividend payments -- indeed, both Annaly and Chimera still offer yields north of 14%! But both have also announced dividend cuts, and rising interest rates can threaten those payouts more.

Investors in insurance companies, which like to invest your premiums at high interest rates, will probably be happier if rates rise. Low rates make some of their interest-dependent offerings, such as fixed annuities, less attractive. Many of these companies are positioning themselves to profit more strongly when rates rise. Prudential (PRU) and MetLife (MET), for example, have acquired life insurers in Japan, hoping to capitalize on a market that historically has kept most of its savings in simple bank accounts.

Be Prepared
Whether interest rates rise or stay low, diversification is your best investment strategy.

If you're invested in mortgage REITs for their high dividends, augment those holdings with other strong dividend-payers. You needn't bail out on mortgage REITs entirely, though, since many of them are still growing their revenue and keeping dividends high. Remember that great dividend payers can often offset the effect of inflation via their dividends alone, leaving stock-price appreciation as gravy.

It's also smart to diversify geographically. While inflation might rise sharply in one region, it won't necessarily do so in another. Include international holdings in your portfolio -- or at least, American companies with considerable foreign revenue. Cisco Systems (CSCO), for example, generates 46% of its revenue outside the Americas, while that number reaches 57% for Abbott Labs (ABT). Such companies are somewhat sheltered from fluctuations in the U.S. economy.

Longtime Fool contributor Selena Maranjian owns shares of JPMorgan Chase. The Fool has created a bull call spread position on Cisco Systems. It owns shares of Abbott Laboratories, Annaly Capital Management, Bank of America, and JPMorgan Chase; and through a separate account in its Rising Star portfolios also has a short position on Bank of America. Alpha Newsletter Account, LLC owns shares of Abbott Laboratories and Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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