Source: flickr user Michael Theis

Recent economic data has given further support to the widespread belief that the Federal Reserve will start raising interest rates later this year. If this happens, it could wreak havoc on the value of bond-heavy portfolios. Here's why rising rates are bad for bonds, and how you can protect yourself from, and take advantage of, the coming higher rates.

The data points to rake hikes in the coming months
The Fed has indicated it would not begin rate hikes before inflation is at or near its target rate of 2%. While the latest consumer price index, or CPI, data shows no gain over the past year, the core CPI -- which excludes the effects of this year's lower gas prices -- shows an annual increase of 1.7%.

When you factor in the low unemployment rate, strengthening real estate market, and other positive economic progress, signs definitely point toward rate increases later this year. In fact, many economists predict they will come as early as September.

Why higher interest rates are bad for bond prices
When rates rise, investors expect all bonds to pay increased interest rates in order to keep up with the market. Existing bonds lose face value to make up for their lower yields; the further away from maturity, the larger the effect.

For example, let's say you buy a 30-year Treasury bond today at the current yield of 3.13% (as of this writing). In other words, you pay $1,000 in order to receive $31.30 in interest payments annually for 30 years, and then will receive your original $1,000 back..

If rates suddenly spike to 4% after one year later -- which isn't a huge move, historically speaking -- that's what yield investors will expect from their Treasury bonds. To produce a 4% yield, the face value of your bond would drop to $782.50.

Now, bond prices and interest rates don't have a perfectly inverse relationship because your bond will once again be worth full face value ($1,000) at maturity. So bond prices use a concept known as yield to maturity, which takes into account the discounted price of the bond, as well as the bond's "coupon rate" or nominal yield. In reality, in the above example, the value of a bond that would produce a 4% yield to maturity would be about $852. Not quite as big of a discount, but still a 14.8% decline from the price you paid.

If rates rise even higher, the effect would be even more dramatic. Here's a look at what today's Treasury bonds could be worth if interest rates spike to 4%, 5%, or 6% in the next few years.

If 30-year yields rise to... In 1 year 2 years 3 years 4 years 5 years
4% $852 $855 $858 $861 $864
5% $717 $721 $726 $731 $736
6% $610 $615 $621 $627 $633

So, if you have a large amount of your assets in long-dated bonds, it might be a good idea to play a little defense while rates are still low.

Two solutions
In a nutshell, the obvious solution is to reduce your exposure to bonds with long maturities. However, the main problem with this is that short-term bonds tend to have much lower yields. For example, a two-year Treasury currently pays just 0.65%. How, then, can we reduce our exposure to long-dated bonds while maintaining an acceptable level of income?

The first strategy is called a bond ladder. This involves staggering the expiration dates of the bonds in your portfolio, so you get a higher yield than you would with just short-term bonds, but with less risk than a portfolio of only long-term bonds.

For example, let's say you divide your bond allocation into six groups at five-year maturity intervals: One-sixth of your bonds will mature in five years, then another one-sixth in 10 years, and so on. By doing this, you'll maintain some exposure to long-term bonds to provide current income, and one-sixth of your bond holdings will mature every five years, allowing you to take advantage of long-term interest rates, which ideally will be higher than they are now.

You could also decrease your overall allocation to bonds and move some money into high-quality dividend stocks. These stocks can pay dividend yields comparable to those of bonds, while giving you some upside potential as well. Plus, many dividend stocks perform well in an inflationary environment, which could offset any declines in the bond portion of your portfolio.

Of course, the best solution for you might be a combination of these two strategies. You could reduce your overall bond exposure and ladder your remaining bond holdings in order to provide extra protection.

Maybe you don't need to act...
If you rely on the bonds in your portfolio for income, and you are fairly certain you won't need to sell your bonds anytime soon, you don't necessarily need to do anything. After all, your income stream will continue as is, and once your bonds mature, you'll receive full face value. However, it's important to be aware that the overall value of your bond portfolio could take a dive in the meantime.

On the other hand, if you're not already retired and don't want to risk a bond-related meltdown in your portfolio, it might be best to reduce your exposure to long-dated bonds -- at least until rates go up.