What Should I Invest in When Interest Rates Go Up?

The Federal Reserve is on track to raise the federal funds rate to 4.5 percent before the end of 2022. Although this is intended to help reduce the rate of inflation in the U.S., many people are becoming concerned about the negative side effects it’s having on the economy. Stocks are already down over 20 percent this year and many financial experts fear we may even be heading into a recession.

With forecasts like this, it can be a scary time for investors. However, as the legendary Warren Buffett once said, be “fearful when others are greedy, and greedy when others are fearful.” Even though the economic landscape may seem bleak on the surface, if you’re willing to look hard enough, you may find some timely opportunities. Here are five places’ investors may wish to consider as interest rates are on the rise.

1) Short-Term Government Bonds

Bonds often get a bad reputation for being boring. Since the Great Recession of 2008, yields have been exceptionally low due mainly to the Fed keeping interest rates close to zero for the better part of the decade.

However, now that interest rates are rising, this is causing bond prices to fall. With low prices and higher yields, many experts are predicting that bonds will see growth over the next year. In an article from Seeking Alpha, they noted that since 1928 bond prices have risen 100 percent of the time after a period of two consecutive years of negative returns. Their conclusion was that this could indicate a strong chance that bond prices will be positive, and probably above average, in 2023. The probability would be even higher if the Fed stops raising rates or even pivots.

While this will eventually affect all bonds, the first place investors might see growth is in short-term bond funds. These funds hold bonds with a maturity of one year or less. As older bonds in the fund mature, they get replaced with less expensive, higher-yield ones. This means that while bond funds may be down now, there’s a good chance for an upswing.

2) I-Bonds

Remember when your grandparents used to give you U.S. Savings bonds for your birthday as a kid? Those same investments have been making a comeback thanks to inflation, and financial experts have taken notice. 

In particular, the ones that people are talking about are Series I bonds. The “I” stands for inflation. These were bonds that were meant to adjust with the cost of living. In the past when inflation was normal, the yield on an I bond was negligible. However, given the recent increase in inflation, those bonds have been paying out well above average – most recently 6.89 percent.

The downside to I-bonds is that they are illiquid. Investors need to hold on to them for at one year before they can be redeemed. Also, if you cash them in within five years of their issue date, you’ll have to forfeit three months’ worth of interest as a penalty.

There is a cap on how much investors can put into I-bonds. Each taxpayer is limited to purchasing $10,000 of bonds per year, so this wouldn’t be ideal for someone with a large nest egg or a substantial amount of money.

3) Dividend Stocks

Dividend stocks are great during periods of high inflation for two reasons.

The first is that a good dividend stock will typically not cut its distribution amount. That means that even if the share price goes down (which generally occurs as the Fed tries to combat inflation by raising interest rates), investors can still count on some positive yield to come from the stock. 

The second is that most companies that have a long history of paying dividends are more financially robust. If the economy starts to contract and the markets start to panic, usually growth stocks will be the first to go down because they take on more risk and debt. However, most dividend stocks are associated with value companies. These are businesses with strong balance sheets which may still be attractive buys even though the overall market has temporarily caused the share price to lower. As an investor, that means less fluctuation as well as a good buy-in opportunity as look to the future.

4) REITs

With so much attention on stocks and bonds, investors sometimes forget that there are other asset classes that can be influenced by high-interest rates. Real estate is one of them, and one of the easiest ways to get involved is by purchasing shares of REITs.

REITs (real estate investment trusts) are publicly traded companies that own commercial real estate and mortgages. They trade just like stocks. However, a big advantage to REITs is that they pay hefty dividends due to a law that the REIT must distribute at least 90 percent of its profits to the shareholders.

Looking back at history, REITs posted positive total returns in 85 percent of periods with rising Treasury yields from 1992 to 2021. The average four-quarter return in periods with rising rates for REITs is 16.55% compared to 10.68% in non-rising rate periods.

Therefore, just like dividend stocks, REITs may offer investors similar benefits: regular distributions and rising share prices.

5) S&P 500 Index Fund

Yes, as we already said, the stock market is down quite a bit in 2022. Financial experts are debating on whether we’ve truly hit the bottom yet or if the market has further to fall.

If you consider what may happen when inflation becomes curbed and Fed eventually reduces interest rates, the markets could stage a comeback as they’ve done in the past. We’ve seen this happen before in 2000 and 2007 in the expansions that took place in the years that followed a Fed pivot on interest rates.

Therefore, now might be a good time to take advantage of the market while prices are low. If there is a recovery in the next one to two years, you’ll be glad you bought when you did.

Find Money to Invest in Your Budget

When interest rates are rising and inflation is high, it can be tough to find any extra money to invest. However, don’t let that derail your efforts and force you to pass up on these opportunities.

A good way to do this is to control your spending now by using a budgeting app like Buxfer. Buxfer connects to your bank and credit card accounts, so you’ll always know how you’re doing financially. This will help you to set limits and reallocate that money towards your investment goals instead.

Even if you don’t come up with a ton of money or are a little unsure about what to invest in, you can go small by using dollar cost averaging. This will allow you to systematically buy shares without having to manually purchase them or attempt to time the market. It’s a simple way to invest and an effective use of any spare funds you can squeeze from your budget.

Featured image credit: Pexels

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