How To Ride Rising Rates It's only a matter of time before we get higher interest rates. Here are four ways to bet on them--and profit.
By Adam Lashinsky

(FORTUNE Magazine) – Rising interest rates are the investment world's proverbial menace at the door. So powerful is the perceived threat of interest rate hikes that markets tumble at the mere hint they may be around the corner. Witness, for example, the 123-point drop in the Dow Jones industrial average on April 20, when Federal Reserve chairman Alan Greenspan uttered this not-so-shocking opinion to the Senate Banking Committee: "It's fairly apparent that pricing power is gradually being restored." The ability of companies to raise prices translates into inflation, you see, and inflation coincides with higher rates, which can choke off business growth and, naturally, the prices of stocks and bonds.

The problem with all this groupthink, however, is that it's often wrong. "Everyone's so focused on the market going to hell the moment the Fed starts raising rates," says Andrew Engel, a portfolio manager with Leuthold Weeden Capital Management in Minneapolis. "What people forget is that the uptick actually is a natural indication that things are getting better. As things get better, this is what is supposed to happen. We'd be more concerned if the Fed wasn't increasing interest rates." In fact, stocks can and do rise along with interest rates. Other factors, notably corporate earnings, are as important as rate hikes--or more so. And even within supposedly interest rate--sensitive sectors like financial services, investors can make money as rates rise.

There are a few certainties in the rate-hike debate, of course. One is the widespread consensus that later this year the Federal Reserve will begin raising the Federal Funds rate, typically expressed as the rate at which banks lend money to one another, from its current 40-plus-year low of 1%. There's also no question that rising rates put a dent in corporate earnings. Higher costs of capital make doing business more expensive, dampening profits.

What's often misunderstood, however, is how much rate hikes hurt--and when. Leuthold Weeden recently identified nine periods since 1955 in which interest rates and stock prices moved up in tandem, which happens precisely because times are good. According to a study by Ned Davis Research, the period after an initial rate hike typically is a better-than-average environment for stocks (see chart). If anything, the anticipation of the actual medicine tends to be worse than the treatment, especially if the Fed acts in a measured way when it begins tightening. In a study of 22 initial rate hikes since 1917, Ned Davis found that the Dow was down an average of 1% in the month before a hike and up nearly the same amount the following month.

Although rate hikes aren't necessarily to be feared, maximizing your returns in such an environment requires some adjustments to your portfolio. Here are four ways to ride those rising rates.

For starters, rethink your approach to bonds. Even though the bond market has held up longer than many experts thought it would, if rates do indeed rise, fueled by inflation, bond prices will move in the opposite direction from their yields. Fixed payments will simply be worth less over time if rates rise. "Someone who has fixed-income exposure needs to realize that we're at the end of the bull run on rates," says Tom Atteberry, manager of the FPA New Income fund, a $1.5 billion bond fund. Atteberry deploys a strategy that focuses on low credit risk and shorter-term maturities for bonds. That won't make a ton of money for investors, but it shouldn't lose them any either.

One fund that plays rate hikes is the ProFunds Rising Rates Opportunity (RRPIX). The strategy of the managers is to bet against the latest 30-year Treasury bill by regularly selling short those bonds. The investment isn't a sure thing, since it requires rates to rise, but the fund's price has spiked by 10% since mid-March as long-term rates have risen.

Another relatively safe way to play a rising-rate market is to seek out companies that benefit from a strengthening global economy. Susan Byrne, CEO of Westwood Holdings, a $4 billion institutional money manager, owns shares of General Electric (GE, $30), which she thinks is being overly penalized for its financial components and underrewarded for its position in the recovering industrial and aerospace sectors. "Rising rates tend to affect companies that need the markets for cheap capital," says Byrne. "So they tend to benefit companies with strong balance sheets and healthy dividends." GE's dividend currently yields about 2.6%, more than passbook savings. Its stock--which has basically treaded water for the past year, far underperforming the S&P 500--trades at a slight discount to the index's overall valuation of about 20 times expected 2004 earnings.

The conventional wisdom on rising rates dictates avoiding banking stocks: Higher rates mean lenders have to pay bigger premiums to depositors. But there are still opportunities in the booming finance sector. Collyn Gilbert, an analyst at investment boutique Ryan Beck, which specializes in banks and thrifts, says a rising-rate environment is a good time to look for banks that focus on businesses, not consumers. Because commercial loans tend to move in concert with the prime rate, lessening the interest rate impact on the lender, she screens for banks with a higher than average percentage of commercial loans. An example: Sterling Bancorp (STL, $27), whose commercial loans make up 57% of its total. Sterling is one of the last remaining independent banks in Manhattan that focus on small businesses, and it has turned in 43 consecutive quarters of double-digit earnings growth.

Another tenet of the rising-rate canon is that anything related to mortgage rates should be shunned. The early stages of rate increases, however, could have the opposite effect: As mortgage rates go up, the frenzy to own a home at still-low rates could grow stronger. Ron Muhlenkamp, manager of the Muhlenkamp Fund, loves to play contrarian, applying his study of economic cycles to a value approach to picking stocks. The studying shows: His five-year annual return of 12.61% thumps the S&P's --1.2% performance over the same period. Muhlenkamp says he's buying companies that feed new-home construction. One of his favorites is kitchen-cabinet maker American Woodmark (AMWD, $66), which is increasing earnings in the 25% range and yet trades for only about 17 times expected 2004 earnings. That reflects a good strategy for any interest rate environment: Find bargains.