What to do with rising interest rates

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(MoneyWatch) Since May 2, the interest rate on the 10-year U.S. Treasury bond has risen from 1.76 percent to 2.56 percent. Though the Fed has signaled that quantitative easing is coming to an end, the timing isn't entirely certain.

The increase in interest rates caused bond prices to fall, and the overwhelming consensus is that rates will rise and now only short-term bonds or cash are safe. Accordingly, money poured out of bond funds. Who would want to own bonds or bond funds when rates rise?

The rest of the story

Sure, it's true that rates have risen. But the predictions that rates will continue to rise may be as inaccurate as the past, when top economists predicted the direction of interest rates correct about a third of the time -- less accurate than a coin flip.

When you think about it, the belief that rates will rise as the Federal Reserve stops buying up bonds is based more on hubris and lack of respect for the market than anything empirical. Markets have proven to be a heck of a lot smarter than these forecasters and surely knew that our Treasury couldn't buy up our bonds forever.

In my experience, I've found that investors with the most confidence in their ability to outsmart the market typically end up taking the biggest beating. So, statistically speaking, when common wisdom dictates that rates will definitely rise over the rest of the year, I put the probability of being right at a tad under 50 percent. The herd is usually wrong.

As for what the 10-year Treasury will yield a year from now, my best guess would be 2.56 percent. History shows that the previous year is the best predictor of next year's rates.

What to do now

I've long been an advocate of buying CDs that pay good rates but have easy early withdrawal penalties. The Ally Bank 5-year CD is still the best example, yielding 1.50 percent with a 60-day early withdrawal penalty. If rates rise, getting out will cost you 0.25 percent, which is a lot lower than a bond with a five-year duration dropping 5 percent if rates rise 1 percent. Think of it as a bond with interest-rate insurance and the 0.25 percent as the deductible.

If you do own bonds, I would caution you against thinking that owning individual bonds will protect you against rate increases. A low-cost, high-quality bond fund like the Vanguard Total Bond Fund (BND) has a laddered bond portfolio. Every month, bonds mature and are reinvested at the higher rates, as long as you don't panic and sell after a loss.

So now that everyone says rates are going to rise, the thing to do is ... nothing.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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