You can take it to the bank: interest rates are going up.
Everyone from Janet Yellen to Donald Trump says it needs to happen. Traders betting through the Fed futures markets agree, pegging the odds of a quarter-point rate hike at the Fed’s December 14 meeting at 94.9%:
More hikes seem likely next year, if oil prices keep rising, taking inflation along with them.
Since higher rates are bad for high-yield assets, does this mean it’s time to give up and accept that 2% dividends are the only income you can expect in this market?
Because there’s an easy way we can protect ourselves from higher rates and still collect a nice 6.8% dividend yield.
It involves buying three often-overlooked investments I’ll show you in a moment. Together, they form a broadly diversified portfolio that gives you reliable downside protection in case our overheating stock market decides to slide.
A 3-Step Plan for Crash and Inflation Protection
To build a portfolio that will withstand higher rates, I’m going to choose a floating-rate business development company (BDC), a hedged bond fund and a floating-rate bond fund. All four have one thing in common: they’re high-income assets that will not go down when rates rise, and can actually go up.
The first pick is a BDC with reliable management and a strong track record: PennantPark Floating Rate Capital (PFLT), a stock that’s had a great year:
PFLT Keeps Soaring
In fact, PennantPark now has a 33.9% total return for 2016, which would concern me if the value of the fund’s assets wasn’t rising in lockstep.
Last quarter, PFLT’s net asset value rose to $14.06 per share, meaning the company is still trading at a slight discount. Granted, that discount was much bigger earlier this year, when the market was less worried about rising rates. Now that hikes seem certain, PFLT is getting close to a crowded trade—but it isn’t quite there yet.
On top of the BDC, let’s add the ProShares High Yield—Interest Rate Hedged ETF (HYHG).
A smart long/short trade keeps this fund from falling when interest rates rise: HYHG shorts US Treasuries and buys corporate bonds. Since both Treasuries and corporates go down when rates head higher, the short offsets the declines in the corporate bonds. And since yields on corporates are much higher than those of Treasuries, HYHG can offer a yield on par with unhedged junk bond funds.
This means HYHG will outperform something like the SPDR Barclays High Yield Bond Fund (JNK) when interest rates are expected to go up. We can see how this plays out by looking at these two funds’ performance in 2016:
HYHG Breaks Out
Notice how HYHG significantly outperformed JNK in the middle of March and after Trump’s surprise win. Both were times when an interest rate hike was widely expected. When March’s expected rate hike failed to materialize, HYHG quickly reverted to JNK’s trend line. If rates don’t go up, expect that to happen again; if they do, look for HYHG to keep outperforming. Either way, the fund is set to survive whatever the Fed does in December and in early 2017.
Finally, we’ll round out the portfolio with the Pioneer Floating Rate Trust (PHD), which invests in floating-rate bonds issued by large companies and governments. The debtors in PHD’s portfolio are safe—in fact, the US Treasury is PHD’s biggest debtor and makes up over 3% of the fund’s total holdings.
That’s right—this fund’s holdings are far safer than junk bonds, yet it offers a junk bond–level yield. Again, it’s no surprise that PHD has attracted more attention recently:
It’s also no surprise that PHD is outperforming JNK, and that outperformance will likely continue if the Fed does, in fact, raise interest rates. If not, the fund’s safe assets mean it will still attract interest and pay its distributions.
Putting it all together, we get a portfolio with a 6.8% dividend yield in three asset groups that will withstand rising interest rates:
A 6.8% Yield Built for Rising Rates
6 More High Yielders to Buy as Rates Rise
PennantPark and the two funds above are terrific buys as the market and interest rates adapt to a Trump presidency. But you’ll cut your risk even further if you add 6 other high-yield investments we just recommended.
These 6 overlooked dividend machines throw off an 8.0% yield, on average, taking your overall yield well above the 6.8% you’ll get from the three investments above. Plus they add an extra layer of diversification and hold their own no matter what rates do.
This is powerful stuff. And it’s critical if you want to build a retirement portfolio that lets you live on dividends alone—without having to sell a single share.
Most people know this is how they should approach retirement, but they struggle to build a portfolio that throws off a healthy payout and holds firm in a rising-rate environment.