How to Invest When the Fed Raises Rates

As anyone who was a tech investor in the late 1990s will tell you, the good times won't last forever. And while there hasn't been a whole lot of "good" in the economy and in the stock market in the past few years, there has been one unarguably growth-enhancing policy in place that looks set to expire soon -- our low interest rates. This change will have drastic implications for consumers and investors alike.

Setting expectations
To stave off economic disaster, the Federal Reserve has chopped interest rates to near zero over the past two and a half years. The Fed Funds rate, or the rate at which banks can lend to other depository institutions overnight, has fallen to between 0% and 0.25% since September 2007, when it stood at 5.25%. Lower interest rates typically encourage borrowing and lower the cost of capital for individuals and businesses alike.

And while it may not feel like the recession is over, given that millions of Americans are still looking for jobs, according to economic data, the recession almost certainly ended last summer. Given the massive amount of money sloshing around in our financial system, the Fed's next move will be to raise rates. In fact, Fed Chairman Ben Bernanke recently testified before the House of Representatives' Committee on Financial Services that plans for tightening are already in the works. The timing of the actual tightening remains to be seen, but most economists think that the first rate increase will come sometime this year. That means many investors may need to adjust their expectations, and their portfolios, in response.

Bonds in the crosshairs
One of the first places that will feel the pinch of higher interest rates is the bond market. Because rates have been so low for so long now, newer bonds simply aren't yielding much. When rates rise, these bonds will be worth less, because investors can simply buy new bonds with higher yields.

To offset some of this interest-rate risk, investors might want to consider keeping part of their bond allocation in short-term securities, such as a short-term bond fund. That way, you're not locked into lower interest rates for years and years on end and you can reinvest in higher-yielding securities sooner. Likewise, you might also want to consider inflation-protected securities (TIPS), which are partially indexed to inflation. As interest rates rise, typically so will inflation. TIPS can ensure that your purchasing power won't be eaten away by rising prices and interest rates.

Lastly, if you have a bit of an appetite for risk, think about a small allocation to high-yield bonds. Although this area isn't nearly as attractively priced as it was closer to the height of the financial crisis, there are still some bargains to be had. Corporate defaults should decrease as the economy continues to improve, which lessens the risk in the high-yield arena. But don't buy here if you can't handle the ups and downs that inevitably come with riskier bond investing.

Taking stock
Beyond the obvious impact on fixed-income instruments, a rising rate environment can also have an effect on stocks. Higher rates can affect how companies borrow money and how they do business, but the stock market typically likes to weigh in on what it thinks about rate hikes. Odds are good that the Fed will have to raise rates while unemployment is still pretty high, which means that the market is likely to react unfavorably. In such a case, investors may find refuge in more defensive plays like Wal-Mart (NYSE:WMT) and PepsiCo (NYSE:PEP).

But looking longer-term, there is one area of the market that should provide pretty decent protection against rising interest rates -- dividend-producing stocks. Stocks that regularly pay out dividends give you an extra shot of income, and because rising rates typically accompany a rebounding economy, that means these companies should have extra cash on hand to increase dividend payouts. Stocks that provide regular payouts should give you a greater chance of staying ahead of rising rates.

To capitalize on this sector, investors might want to consider a low-cost exchange-traded fund that focuses on high-yielding stocks. One such fund is the Vanguard Dividend Appreciation ETF (NYSE:VIG). This ETF comes with a low 0.24% price tag and includes some of the following names:

Source: Yahoo! Finance.

Remember that it's a question of when interest rates will go up, not if they will. By setting expectations and prepping your portfolio now, you can avoid getting hit further down the road when rates begin their inevitable ascent.