5 Ways To Protect Your Bond Portfolio From Rising Interest Rates
by: David Twibell
The Federal Reserve recently raised its target federal funds rate
for the first time since March 2000. This could be just the tip of
the iceberg, though, as many experts believe rising inflation and
a strengthening economy will spur continued rate hikes for the foreseeable
future.
This is bad news for bond investors, since bonds lose value as interest
rates rise. The reason stems from the fact coupon rates for most
bonds are fixed when the bonds are issued. So, as rates rise and
new bonds with higher coupon rates become available, investors are
willing to pay less for existing bonds with lower coupon rates.
So what can you do to protect your fixed-income investments as rates
rise? Well, here are five ideas to help you, and your portfolio,
weather the storm.
Treasury Inflation Protected Securities (TIPS)
First issued by the U.S. Treasury in 1997, TIPS are bonds with a
portion of their value pegged to the inflation rate. As a result,
if inflation rises, so will the value of your TIPS. Since interest
rates rarely move higher unless accompanied by rising inflation,
TIPS can be a good hedge against higher rates. Because the Federal
government issues TIPS, they carry no default risk and are easy to
purchase, either through a broker or directly from the government
at www.treasurydirect.gov.
TIPS are not for everyone, though. First, while inflation and interest
rates often move in tandem, their correlation is not perfect. As
a result, it is possible rates could rise even without inflation
moving higher. Second, TIPS generally yield less than traditional
Treasuries. For example, the 10-year Treasury note recently yielded
4.75 percent, while the corresponding 10-year TIPS yielded just 2.0
percent. And finally, because the principal of TIPS increases with
inflation, not the coupon payments, you do not get any benefit from
the inflation component of these bonds until they mature.
If you decide TIPS makes sense for you, try to hold them in a tax-sheltered
account like a 401(k) or IRA. While TIPS are not subject to state
or local taxes, you are required to pay annual federal taxes not
only on the interest payments you receive, but also on the inflation-based
principal gain, even though you receive no benefit from this gain
until your bonds mature.
Floating rate loan funds
Floating rate loan funds are mutual funds
that invest in adjustable-rate commercial loans. These are a bit
like adjustable-rate mortgages,
but the loans are issued to large corporations in need of short-term
financing. They are unique in that the yields on these loans, also
called “senior secured” or “bank” loans,
adjust periodically to mirror changes in market interest rates. As
rates rise, so do the coupon payments on these loans. This helps
bond investors in two ways: (1) it provides them more income as rates
rise, and (2) it keeps the principal value of these loans stable,
so they don’t suffer the same deterioration that afflicts most
bond investments when rates increase.
Investors need to be careful, though. Most floating rate loans are
made to below-investment-grade companies. While there are provisions
in these loans to help ease the pain in case of a default, investors
should still look for funds that have a broadly diversified portfolio
and a good track record for avoiding troubled companies.
Short-term bond funds
Another option for bond investors is to shift their holdings from
intermediate and long-term bond funds into short-term bond funds
(those with average maturities between 1 and 3 years). While prices
of short-term bond funds do fall when interest rates rise, they do
not fall as fast or as far as their longer-term cousins. And historically,
the decline in value of these short-term bond funds is more than
offset by their yields, which gradually increase as rates climb.
Money-market funds
If capital preservation is your concern, money market funds are
for you. A money-market fund is a special type of mutual fund that
invests only in very short-term money market instruments. Since these
instruments usually mature within 60 days, they are not affected
by changes in market interest rates. As a result, funds that invest
in them are able to maintain a stable net asset value, usually $1.00
per share, even when interest rates climb.
While money-market funds are safe, their yields are so low they
hardly qualify as investments. In fact, the average seven-day yield
on money-market funds is just 0.70 percent. Since the average management
fee for these funds is 0.60 percent, it does not take a genius to
see that putting your capital in a money-market fund is only slightly
better than stashing it under your mattress. But, because the yields
on money-market funds track changes in market rates with only a short
lag, these funds could be yielding substantially more than 0.70 percent
by the end of the year if the Federal Reserve continues to hike rates
as expected.
Bond ladders
“Laddering” your bond portfolio
simply means buying individual bonds with staggered maturities
and holding them until
they mature. Since you are holding these bonds for their full duration,
you will be able to redeem them for face value regardless of their
current market value. This strategy allows you to not only avoid
the ravages of higher rates, it also allows you to use these higher
rates to your advantage by reinvesting the proceeds from your maturing
bonds in newly-issued bonds with higher coupon rates. Diversifying
your bond portfolio among 2-year, 3-year, and 5-year Treasuries is
a good start to a laddering strategy. As rates rise, you can then
broaden the ladder to include longer maturity bonds.
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