Will Rising Rates Upend Your Bond Fund?

US News

In a world of uncertain economies and volatile share prices, it's little wonder so many investors have fled lately to the relative security of fixed-income funds. According to data provider Lipper, fixed-income mutual funds and exchange-traded funds attracted net inflows of $857 billion in the four years through 2011, while equity funds posted net outflows of $44 billion.

But there are risks with any investment, bond funds included. One big risk for bond-fund holders at the moment is that interest rates will rise. It might seem unlikely right now, with the economy stuck in low gear, but eventually rates are certain to rise from today's rock-bottom levels. That will indicate a reviving economy but it could also hurt portfolios heavy on fixed-income assets.

[See 6 Not-So-Great-Alternatives to U.S. Treasuries.]

The reason: Rising interest rates make new, higher-paying bond issues more attractive than outstanding issues. A fall in the price of a bond that you (or, more likely, your fund) hold will raise its yield for whoever might buy it, but not for you. You could be stuck with a capital loss if you sell after rates rise.

Lots of folks say there is a bubble in bonds and that people who hold them are going to pay heavily once it bursts, which is something a rate rise could hasten. Some bonds look frothier than others, though.

There may well be a bubble in Treasury issues, which are in such demand that the yield (which moves inversely to price) on the widely watched 10-year note has fallen to lifetime lows, at one point this summer hitting 1.4 percent. That's about what inflation is running, which tells you that folks are so wary of any other investment that they're willing to park their money with the U.S. government for effectively nothing in return, except preservation of capital.

But that doesn't mean there's a bubble in corporate debt, some say. "The bubble discussion is more in the area of Treasuries," says Paul Hickey, founder of the Bespoke Investment Group.

Bond analysts measure fair value by looking at the difference, or "spread," between yields on the "risk-free" benchmark that is government debt and yields on non-Treasuries. Right now, the spread between the U.S. 10-year yield and high-yield (or "junk") debt, for example, is around 6 percentage points, about the historical average. High-yield issuers are flush with cash, and default rates are historically low.

Still, "if Treasury yields rise, yields on all fixed-income [assets] will most likely rise," says Hickey. "Maybe not to the same degree as in Treasuries," he says, but "investors who are holding fixed-income ETFs or mutual funds would see those funds get hit."

Right now, the Federal Reserve is promising to keep rates low through 2014, but the Fed is not the only determinant of interest rates. If the United States suffers another credit downgrade or inflation spikes, the market could precede the central bank.

Should fixed-income investors be preparing now for a rise in rates? First, unless you're a relatively sophisticated investor, it's probably best to check with an adviser before you do anything. But there are ways to mitigate the impact of a return to rising rates, and, of course, it's easier to act with ETFs than with mutual funds.

[See Preparing for a Bond Bubble: 6 Investing Tips.]

For starters, consider moving to shorter-maturity issues if you're not there already. These are less sensitive to changing interest rates than longer-maturity bonds (they have shorter "duration," to use the technical term). Within ETF offerings, there are several ways to do this, like the iShares Barclays 1-3 Year Treasury Bond ETF (symbol:SHY), the SPDR Barclays Capital 1-3 Month T-Bill (BIL), and the Vanguard Short-Term Government Bond Index (VGSH).

You can get higher yields with similarly short maturities through ETFs like Vanguard Short Term Corporate Bond Index (VCSH), which holds investment-grade issues that mature in five years or less, or SPDR Barclays Capital High Yield Bond (JNK), for low-rated bonds.

The risk with short maturities, though, is that interest rates don't rise and you get stuck with lower-yielding assets than you could have had otherwise.

There are other approaches, though. TIPs funds--for Treasury Inflation-Protected Securities--offer partial defense. They adjust for inflation, which tends to rise when interest rates do. The risk: In a period of deflation--like we had for a few months in 2009--the issuers suspend distributions. Also, rising inflation is not necessarily the same as rising interest rates, though one tends to accompany the other.

"We could be in an environment where rates are going up but there is no increase in inflation," notes Nathan Rowader, director of investments at Forward Management, which manages about $5.5 billion. "In that scenario, TIPS don't work as well."

You might also be tempted by floating-rate ETFs, like the PowerShares Senior Loan Portfolio (BKLN). It tracks a portfolio of senior bank loans--secured, variable-rate debt instruments issued by financial institutions that rate below investment grade. Bank loans are in favor when the market thinks rates will rise.

But, notes Rowader: "It's almost the exact opposite [of TIPS]. You get better protection from [rising] rates but if you have inflation, you might not get as much protection from those funds."

Should you consider junk bonds? They're less sensitive to rate changes, notes Rowader, because issuers have collateral that appreciates amid inflation, not incidentally reducing credit risk (the risk of default). Indeed, junk-bond ETFs like iShares iBoxx $ High Yield Corporate Bond (HYG) and JNK did rather well during a period of rising rates two years ago.

[See High-Yield Bonds Hit a Few Bumps, But Still Appeal to Risk-Takers.]

"I think a lot of individual investors--you can see it in fund flows--are moving toward passive high-yield options like junk or long-dated corporate bonds because they want the yield," says Rowader. "But I think they're ignoring the risk of the extra duration and the credit risk that comes with that."

If you're really feeling adventurous, you can buy funds that short bonds or try to double or triple their performance. "An investor could look at those, but we would by no means go anywhere near any sort of leveraged ETF," says Hickey. "Historically they've done a terrible job of tracking the indices they're supposed to track."

Or you could just bail on bonds altogether and dive into equities for the long term. "What we generally suggest is, given the low yields, you almost have a better risk/reward in high-quality equities or equity ETFs," says Hickey.

To be sure, most investors would be ill-advised to try any of these strategies on their own. There's a reason we hire fund managers, even if some of them seem overpaid at times.

"It's very hard to predict when interest rates are going to change," says Rowader. "If you have a good fund manager that has the flexibility to allocate across different asset classes to get income, you're going to be getting some extra teeth in determining when it's best to make those changes."

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