10 ways to profit from an interest rate increase

Although many investors and analysts are focused on the fact interest rates have been held artificially low until recently, they have been declining since the early 1980s. Given this protracted period of declining rates, it is more likely a trend of rising interest rates could continue for several years to come. Rising rates change the landscape of the marketplace for businesses and individual investors.

Here's how investors can profit from rising interest rates.

Brokerage firms earn money from the interest earned on cash balances held in client accounts. Naturally, they earn more interest when rates are higher. A review of the 2003-2004 period, when the federal funds rate rose from 1.25% to 2.25%, shows major online brokers such as E*Trade and Charles Schwab enjoyed a 38% increase in interest income and a resulting 10% improvement in operating profit margins.

Cash-rich companies will also benefit from rising rates, earning more on their cash reserves. Investors can look for companies with low debt-to-equity (D/E) ratios or companies with large percentages of book value in the form of cash.

Individuals with adjustable-rate mortgages (ARMs), or companies with adjustable rate financing of any kind, would be well-advised to refinance with fixed-rate financing, locking in the lowest possible interest rates for the long term. (For related reading, see "Mortgages: Fixed-Rate Versus Adjustable-Rate.")

Individuals or businesses planning major purchases or capital expenditures should consider buying now while they still have the ability to lock in low long-term rates. Purchases made before interest rates begin to significantly rise can result in substantial savings in financing charges and overall long-term costs.

Most companies in the technology and healthcare sectors hold on to greater amounts of profits as retained earnings to reinvest in growth, rather than paying them out in the form of dividends. Past history shows that such a stance usually leads to increased revenues in a rising rate environment. In the past 13 periods of rising interest rates – over the past half century – the healthcare and technology sectors experienced average gains of 13% to 20% during the first year following an interest rate increase. In comparison, overall average gains for the S&P 500 Index were only between 6% and 7%.

Bond investors can decrease portfolio volatility during rising-rate environments by moving to bonds with shorter terms to maturity or by purchasing bonds with coupon rates that float in concert with the market rate. (For related reading, see "Is It Time to Buy Floating Rate Bonds?")

Payroll processors, such as Paychex and Automatic Data Processing, customarily maintain large cash balances for customers in the periods between paychecks, when the money is distributed as payroll. These firms should see improved interest revenues when interest rates rise.

Individuals or businesses with unneeded property or other assets may be able to profit from selling such assets before rates begin to rise. Buyers are likely looking to buy now when they can still lock in low, long-term rates, so they may be willing to pay premiums to acquire needed assets before rates begin going up.

Rising rates generally mean rising prices as well. Businesses that can lock in long-term contracts with suppliers may be able to enjoy better margins by avoiding increased prices for as long as possible.

Real estate prices tend to rise with, and often even outpace, interest rates. Buying real estate or investing in real estate investment trusts (REITs) is another way to realize profits from a rising rate environment.

Rising interest rates may sound like a bad thing for those who need to take out a loan or buy something on credit, but investors can profit by planning ahead and purchasing the right types of investments.

(For related reading, see "6 Ways Retirees Can Capitalize on Higher Rates.")