Analysts have been trying to predict when the Federal Open Market Committee (FOMC) will raise interest rates for years now, but no real steps have been taken… yet. The next chance for the Fed to decide to raise rates is coming up this month, and many believe it will actually happen this time.  

So how do you react? Do you play it safe and settle for whatever short-term yield you can get, or roll the dice and bet on longer-term securities with higher payouts?

The more cautious approach will earn you next to nothing in this meager environment. The average 12-month bank CD is currently paying a paltry 0.27%. A one-year Treasury will only get you double that, about 0.50% — that’s just $500 in annual income on a $100,000 investment. Good luck living off that.

On the bright side, at least your principal will be secure if and when rates finally do start to climb.

On the other hand, you can find corporate bonds paying almost ten times as much. The average 20-year A-rated corporate bond is currently yielding 4.4%. That’s $4,400 in annual income instead of $500.

Now we’re talking.

Unfortunately, these bonds won’t mature for another two decades. The longer the maturity, the more vulnerable a fixed income security is to the next rate tightening cycle. The further interest rates rise, the less these bonds will be worth in the eyes of the market.

That 4.4% yield won’t be much consolation if the value of the bond falls 10% and erodes your principal.

A Third Option For Your Income Portfolio
Fortunately, there is a door number three — a unique asset class that offers high upfront payments and protection from rising rates. I’m talking about fixed-to-floating preferreds, which work just as you might expect. These stock/bond hybrids carry a fixed coupon for a certain period of time (often 5 or 10 years). After that, the payouts become adjustable and float along with prevailing market conditions.

Some are issued with floating rates from day one. Typically, the payout on these instruments is tied to a common short-term benchmark plus a pre-determined spread, say the Libor plus 3.0%. Whenever rates rise, so do the payouts on these preferreds, making them much less susceptible to rate hike fears.

It wasn’t that long ago that short-term interest rates were at 5.25%. If we return to that level, you sure don’t want to be locked in at 4.4% for the next 20 years. And that’s the beauty of these floating rate preferreds.

Here are a few options to consider:

Action to Take: These perpetual preferreds have no stated maturity date, but can be bought and sold at any time. Like any corporate IOU, they do carry credit risk, as well as some interest rate sensitivity — although not nearly as much as their fixed income counterparts.

Even better, the distributions are considered qualified dividend income, which is taxed at a lower rate than ordinary bond income.

If you’re uncomfortable holding individual preferreds, you might want to consider the PowerShares Variable Preferred (NYSE: VRP). This fund offers broad exposure to a basket of 90 holdings, most of which are issued and backed by big banks and insurance companies.

VRP has attracted $120 million in new assets over the past three months and offers a robust yield of 5.0%.

P.S. Want to know the simplest way to “recession-proof” your portfolio? These eight ‘Hall of Fame’ stocks gained 10% during the Great Recession… and they can do it again. Learn more about this elite asset class in my High-Yield Hall of Fame report here. 

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