As Rates Rise, Keep Bond Strategy Steady - TheStreet

As Rates Rise, Keep Bond Strategy Steady

Financial advisors agree on one thing: Don't switch up your fixed-income portfolio as interest rates increase.
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) -- Most economists agree about one thing: Interest rates are bound to rise in 2010. That could hurt plenty of

bond funds


When rates rise, bond prices tend to sink. If rates rise by 1 percentage point in 2010, as many economists expect, shares of the average intermediate-term bond fund would drop by around 4%. Such a loss could come as a jolt to the millions of investors who have been pouring into bond funds lately seeking safety.

How should you protect against the hazards of rising rates? Financial advisors disagree. Some suggest making tactical moves to lessen the risk of losses, while others urge investors to buy and hold, waiting patiently for the storm to subside. Though either approach can produce decent results, you should pick one and stick with it when the inevitable rate rises appear.

Vanguard Group

is firmly on the side of sitting still. "You shouldn't change your long-term strategy just because rates might go up in the near term," says Stephanie Smith, a principal with Vanguard. "For long-term investors, rising rates can be a good thing."

Smith notes that as bond holders receive interest income, they can reinvest the cash in more bonds. When rates rise, the yields on reinvestments climb. Over time, higher yields can compensate for the declines in share prices that occur when rates increase.

Vanguard provides illustrations of how typical bond funds would perform over seven years during periods of rising and falling rates. In one example, a fund yielded 4%, and interest rates dropped by 2 percentage points during the first two years. The share price would rise, and the annualized return for the two years -- including interest income and share appreciation -- would be more than 8%. Then the interest rate remained at 2% for the next five years. For the full seven-year period, the total annualized return would be only 3.2%. The meager result occurred because the fund would have to reinvest principal at the 2% rate.

The fund would have done better if rates rose by 2 percentage points in the first two years and then remained at 6% for the next five years. Because of the rate rises, the fund would lose money during the first two years. But then results would improve as the fund reinvested at higher rates. For the seven years, the annual return would be 4.2%.

As you design your bond portfolio, keep in mind how changes in rates can affect returns, Vanguard's Smith says. "Investors should be mentally prepared for periods when rates rise and share prices fall," she says.

To help avoid panic when rates go higher, set aside cash in money-market funds. Those hold their value during rate rises. In addition, diversify your portfolio, holding a mix of short-, intermediate- and long-term bonds. Short bonds lose less when rates rise, while longer bonds excel during periods of falling rates.

While the Vanguard approach can be sensible, some experts urge investors to limit losses by shifting holdings in anticipation of rate rises. To protect against rising rates this year, consider adding a bank-loan fund to your bond portfolio, says Bill Davison, managing director of


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investment management unit.

The funds invest in loans made by banks to corporate customers. The interest payments on bank loans adjust every 90 days or so, rising along with benchmark rates. Because of the adjustments, bank loans tend to avoid losses during periods of rising rates.

After being crushed during the credit crisis of 2008, bank-loan funds rebounded in 2009, returning 41% for the year. Despite the rally, many bank loans still sell at discounts and yield more than 8%. While many bank loans are rated below-investment grade, Davison says they can be reliable investments. "The loans are relatively safe because they are secured by equipment or receivables," he says.

Along with bank loans, investors should emphasize high-yield bonds, says Zane Brown, fixed-income strategist for Lord Abbett. Investing in bonds that are rated below-investment grade, the high-yield funds sometimes rise when rates climb and many high-quality bonds decline. This occurred in December. For the month, the yield on 10-year Treasuries advanced from 3.3% to 3.8%. That rise hurt Treasury bonds, and the average long government fund declined 7.1% for the month. At the same time, high-yield funds rose 2.9%. "For 2010, we are likely to see more of the same performance, with high-yield bonds improving while Treasuries decline in price," Brown says.

High-yield bonds have been climbing as the outlook for the economy improves, and investors worry less about the risk of defaults. Brown says that, if the economy continues to strengthen, prices of high-yield bonds will rise in 2010. He worries that prices of Treasuries will continue to deteriorate as the government floods the market with debt.

For protection, investors should always stay diversified, holding a mix of different kinds of bonds, Brown says. But in the 2010, investors should emphasize high-yield bonds and be light on government issues.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.