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Bond Investors: Heed Warnings About Rise In Rates

It's important to keep perspective. While investors should be mindful of rate risks, the Federal Reserve has committed to keep borrowing costs low as long as unemployment remains high. That means a sharp rate increase is unlikely in the short term. However, the Fed could begin to push rates higher if the pace of economic recovery picks up, and inflation rises above its current 2 percent.

With inflation risks in mind, last week star bond trader Bill Gross, manager of the world's largest mutual fund, Pimco Total Return, offered advice in a commentary to investors: "You should avoid (long-term bonds), and confine your maturities and bond durations to short/intermediate targets supported by Fed policies."

Long-term bonds are generally defined as those that mature, or pay back principal, over six years or longer. A better option, he says, are short-term bonds that generally mature in less than three-and-a-half years, and intermediate-term bonds maturing in less than six.

The shorter the average maturity duration of bonds in the portfolio, the less vulnerable the fund will be to rising rates.

Morningstar bond fund analyst Michelle Canavan has identified four bond funds that offer strong potential to avoid losses when rates rise. Each fund has an average portfolio duration that's below the average of its peers. Each also possesses strengths that earned the fund either a silver- or bronze medal rating from Morningstar analysts. Those ratings are a subjective system that attempts to gauge a fund's performance prospects, not just its past record. The scale runs from gold to silver, bronze, neutral and negative.

The four funds:


The average duration of this fund's portfolio is about two years, in line with the average of the short-term bond fund category. Its managers tend to favor corporate bonds while many funds in the category lean toward government bonds. This preference introduces more credit risk from potential defaults, but can also help boost the fund's yield and returns over the long run.

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