As investors saw their nest egg deteriorate in the great recession of 2008, many moved their money into bond funds as a safe haven to protect their assets from decreasing stock prices. As interest rates decreased to near zero and continued to remain low, bond funds flourished. Many investors became comfortable with bond returns as they missed out on the continued stock market recovery. This came to a screeching halt in the fourth quarter of 2010 as investors saw rising interest rates push down the prices of fixed income (bond) securities.

According to Lipper Inc., a unit of Thomson Reuters, diversified stock funds increased by an average of 11.4% in the fourth quarter of 2010 alone. In that same time period, intermediate-term investment-grade bond funds lost 0.9% and continued to lose value in the New Year. So what should investors do in a time of rising interest rates?

Diversify

Any prudent investment advisor or competent financial professional is always going to recommend a diversified portfolio in any economic conditions. Many investors think only of market risk. However, not diversifying a portfolio can subject an investor to other risks often not considered such as interest rate risk and inflation risk.

Short-term Bonds

There is an inverse relationship between bond prices and interest rates. As interest rates increase, bond prices decrease in value. There is also a direct correlation between the duration of a bond and the decrease in value when interest rates rise (volatility). A short-term bond fund that typically has a shorter duration than an intermediate-term or long-term bond fund will see a less significant decrease in value when interest rates are rising. Therefore, investors can position all or a portion of their bond holdings in a short-term bond fund. Although this will not prevent a decrease in value during rising rates, the decrease should be less significant than longer term bonds. In addition, certain long-short bond funds also offer bond like returns with a strategy of managing the fund so the duration is zero. Often, these funds come with a fairly hefty internal cost.

Commodities

From the orange juice we drink to the energy that heats our home, commodities can be found all around us. Many low-cost commodity Exchange-Traded Funds (ETFs) allow the average investor access to commodities. Often as interest rates rise, inflation quickly follows. Commodities typically increase in value as inflation increases. Commodities have a high standard deviation (risk) and volatility, but can serve as a compliment to a portfolio in a rising interest rate and inflationary environment.

Stocks

After the last three years, many investors still cringe at the thought of investing in stocks. However, stocks continue their quiet recovery that led to an average return in 2010 of 17.1% in a diversified stock fund according to According to Lipper Inc., a unit of Thomson Reuters. Stocks tend to have an inverse relationship to bond prices.

Inflation-Linked Bond

Inflation-linked Bonds, often called Treasury Inflation Protected Securities or TIPS, provide a hedge against inflation, but are not a perfect solution to rising interest rates. Although the principle of each bond increases with inflation, the value of TIPS is still subject to a decrease in price as interest rates rise. As inflation follows rising interest rates, TIPS provide a place to protect assets against inflation. Although there are exceptions, TIPS should often be held in a tax-deferred account for tax purposes.

What Now?

With many investors shaken by the decrease in bond funds, it provides a good time to evaluate the asset allocation of your portfolio. Many investors may find they can hedge against rising interest rates and diversify their portfolio further by using some of the strategies outlined above.