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How to invest in a rising interest rate environment

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Roger Wohlner
Updated March 7, 2024

In a nutshell

Following its December 2023 meeting, the Federal Reserve announced that it would maintain benchmark interest rates at 5.25 to 5.5% in a move designed to give the Fed time to evaluate whether those rates would keep inflation in check through 2024.

  • Although the consensus among many market experts suggests a drop in rates later in 2024, some analysts have expressed doubt that inflation is tamed, which could mean elevated rates for longer.
  • Continuously high rates are also a concern due to risks of bank failures, stock market instability, mortgage rates and global economic uncertainty.
  • In that event, a working understanding of how to invest in a high interest rate environment could be useful.

Bonds vs. stocks when interest rates and inflation are high

Rising interest rates and high inflation impact how people invest in both stocks and bonds. Some impacts will be negative, but with the right game plan, your investments will thrive as interest rates rise.

Bonds

The impact of rising interest rates on bonds is pretty straightforward. Rising interest rates will cause the price of existing bonds to drop. This is true of individual bonds as well as bond mutual funds and ETFs.

Bond mutual funds and ETFs are especially susceptible to rising interest rates as the funds never mature, unlike with individual bond holdings.

Some potential suggestions for bond investors in a rising interest rate and rising inflation environment include:

  • Invest in shorter-duration bond mutual funds and ETFs. Shorter-duration funds will be less susceptible to rising interest rates than longer-duration funds.
  • Ladder the maturities of individual bonds. Having bonds maturing at different times over a period of several years allows you to reinvest the proceeds of the maturing bonds into new bonds with presumably higher interest rates.
  • Consider investing in inflation-protected Treasuries or TIPs. These are Treasury securities whose interest rate adjusts periodically to keep up with inflation. TIPs are available as individual bonds or in mutual funds and ETFs.

These strategies should be considered in the context of your overall portfolio and your investment strategy to determine if they are right for you.

Stocks

Stocks can be a solid hedge against both rising interest rates and rising inflation. Companies that can raise prices without sacrificing demand for their products (for example, food staples or gasoline) have “pricing power” and are most likely to benefit in this type of environment.

Companies that typically use a lot of debt to finance their operations could find their earnings squeezed in a rising rate environment. They will find that new borrowing is more expensive, and unless they can raise their prices to a level that offsets these higher borrowing costs, their bottom line – and their stock price – could suffer.

Not only can higher interest rates and inflation impact individual stocks for the reasons just given, but the negative expectations that investors might feel towards the economy can also have a negative impact on stocks generally.

The value of diversification

A diversified portfolio is one of the best ways an investor can position their portfolio against the effects of rising inflation, rising interest rates and other factors.

A diversified portfolio will include a variety of investments and investment types that perform differently under different economic conditions. Correlation is what investing experts call the tendency of some investments to move with the market as a whole or with other similar investments. A diversified portfolio is one that isn’t highly correlated with the economy or markets – or itself.

A diversified portfolio might include a combination of stocks, bonds, cash and alternative investments. Within an asset class like stocks, there might be diversification by industry sector, market cap, growth, value and location. For bonds, diversification can be created by holding bonds with longer and shorter durations, as well as U.S. Treasuries and corporate bonds. Alternative investments could include assets like real estate or gold.

Is it possible to hedge against inflation?

While there are no perfect hedges against the inflation that often accompanies a rising interest rate environment, there are some investments that can help hedge your portfolio against the impact of inflation.

Stocks

Stocks generally outpace inflation in the long run. However some sectors may hold up better in the face of inflation than others.

As mentioned above, investors should look for stocks with pricing power. Banks are a sector that will likely have pricing power in a rising interest rate environment stemming from high inflation. Banks make money on loans, and they will benefit from rising interest rates. Insurance companies are another stock sector that is likely to benefit from rising rates because much of their portfolio is invested in bonds.

In general, the S&P 500 will tend to be a good hedge against inflation over time. The index contains a number of technology companies as well as companies in banking and commodity related companies.

Gold and commodities

Gold has traditionally been a hedge against inflation. Gold is not perfect, and the metal itself doesn’t pay any interest, so buyers of gold will not benefit from any increase in interest rates. Gold is considered a store of value by many investors, but owning gold can be a hassle because you have to make arrangements to store the metal. As an alternative, research gold ETFs or mutual funds.

Many commodities can be a hedge against inflation. “Commodities” is a broad category that includes such staples as grains, cattle and livestock, orange juice, natural gas and various foreign currencies. Typically, commodities are traded as future contracts. The inflation hedge is tied to the level at which the prices of these commodities outpace inflation. An alternative to directly investing in commodities or futures contracts is buying a commodity-based ETF.

Real estate

Investing in real estate has historically been a hedge against inflation. Real estate can act as a hedge against inflation because there is only so much land available. A commercial or residential property in an area with strong communities will often retain its value or see an increase in value as prices rise. Like any investment, an investor needs to perform their due diligence to ensure that they purchase a solid property.

Rising interest rates could put a damper on the price of real estate, however. Rising interest rates can make real estate tougher to afford for prospective buyers who need to finance their purchase through a mortgage. We saw evidence of this in 2023, when rates jumped from 6.09% in February to 7.79% in October of that year.

The AP Buyline roundup

Investing in a rising interest rate environment can be a challenge. Rising interest rates impact various investments in different ways. When coupled with rising levels of inflation, this creates an exceptionally challenging environment for investors. It makes sense to step back and think through how both factors will impact investments you hold or are considering.

AP Buyline’s content is created independently of The Associated Press newsroom. We might earn commissions from links in this content. Learn more about our policies and terms here.