Investors Face Frustrating Field

When mutual fund investors open their second-quarter statements, the returns will probably seem lackluster at best.

For the quarter ending June 30, the same day the Federal Reserve made its long-awaited rate hike of 0.25%, the major stock market indexes were essentially flat. And most bond funds were negative. Even before the first rate increase in four years had taken hold, the markets had already anticipated the start of a new, higher interest-rate era.

"At this point, everybody who hasn't been living under a rock knows that interest rates are going to rise," says Paul Nastasi, a certified financial planner with A.J. Perry and Co., Inc. in Baltimore, Md., who manages client portfolios of mutual funds. "The market has already done a lot of the worrying for you."

Mutual fund investors who want to tweak their holdings to accommodate the new interest rate environment could be frustrated, adds Nastasi. "You're almost too late."

One problem is, there's really no safe harbor, investment experts agree. "Rising interest rates hurt stocks, but they hurt bonds even worse," says Nastasi.

When rates are on the increase, certain stocks such as banks and mortgage companies, tend to take a hit because they are sitting on portfolios of lower-rate loans, but need to pay out interest to depositors and investors at newer, higher interest rates.

Mark Kiesel, a portfolio manager with the prominent bond mutual fund company PIMCO of Newport Beach, noted that some major companies have already attributed poor performances to the credit tightening: General Motors ( GM), Wal-Mart ( WMT), Target ( TGT) and Washington Mutual ( WM).

"This is a horrible time for equities," he says. "There are no tax cuts to stimulate economy."

With their credit restricted, consumers borrow less and buy fewer things. Home refinancing drops, and fewer homeowners purchase new appliances or undertake landscaping projects. Corporations find the cost of doing business goes up and their profits can go down. Eventually the return on bonds might seem more attractive than the return on stocks.

For fixed-income investors, the damage report is even more dire. Bonds have been hit hard and more punishment may be in store. Kiesel notes that in the past year, the yield on the 10-year Treasury bond has gone from a low of 3.07% to more than 4.62%, as of June 30. As the yield on bonds rises, the price of individual bonds declines, as does the net asset value of bond funds.

"Bonds are going to get clobbered in general," says Nastasi.

So what are mutual fund shareholders to do? They might just have to wait out some of the pain and remember why the Fed is raising rates in the first place.

"The economy is growing," says Christopher Davis, equities fund analyst at Morningstar, Inc., a Chicago mutual fund rating firm. "Employment is starting to pick up."

At a recent Morningstar conference, says Davis, the consensus among fund managers was that most stocks are pretty well valued and even overvalued. Many said they couldn't find companies worth investing in and were sitting on lots of cash.

Investors should be leery of fund families that launch new funds as a higher interest-rate play. "We look poorly on fund companies that launch trendy flavors of the month," Davis says. "It's sort of a brazen attempt to make a quick buck. These funds are often launched at the wrong time, just when it would have paid to invest in an out-of-favor investment class."

For the past five years, small capitalized stocks have outpaced all other equity categories and are up about 6.5% this year, Davis says. But the time might be right for large-cap growth stocks, which have earned only about 1.4% this year, blue chips like General Electric ( GE), American International Group Inc. ( AIG) and Microsoft ( MSFT).

Diligent mutual fund managers have, of course, already taken action to position shareholders for the new higher-rate order.

"We're shortening our maturities in our portfolios," says Kiesel of PIMCO. He recommends that investors stick to bonds with maturities of five years or less. Currently, he says, the yields on longer bonds are not high enough to make the risk of holding them worthwhile.

"I don't think now is the time to take more risk," he says. "Spreads are very tight and you're not getting paid to take on longer maturities. The bottom line today is that cash is king."

He advises avoiding Treasuries, which are attractive to foreign investors, and can be subject to price swings due to the dollar depreciation and the budget deficit. Kiesel recommends instead global bonds, U.S. Treasury Inflation-Protected Securities, or TIPS, and, for those in higher tax brackets, short-term municipals bonds.

The last three tightening cycles, Kiesel says, took between 13 and 15 months. Because the Fed started talking this one up so early, we could be as close as three months away from the end. In that time there will probably be a buying opportunity, when the 10-year bond hits 5.25%, he predicts.

At the small but highly rated Greenspring Fund ( GRSPX) outside Baltimore, portfolio manager Charles "Chip" Carlson says the value fund aims to do well in hard times like now.

The fund invests in undervalued companies and sectors -- its largest holding is truck manufacturer Wabash National ( WNC) and it currently favors property/casualty insurers like United National Group ( UNGL) and W.R. Berkley ( BER). Carlson says that insurers are piling up cash by collecting premiums and will be able to re-employ them at higher interest rates.

Greenspring also invests in a special class of higher-yielding bonds known as "busted convertibles." These are bonds convertible to company stock at a set price, but are considered "busted" when a company's stock price tumbles below the convertible price.

Carlson says he chooses them with care, selecting bonds with an average duration of 2.3 years, a 6% yield to maturity and backed by a strong company balance sheet. "The companies aren't busted," he says.

Many busted convertibles are from high-tech companies of the late 1990s whose businesses are strong but whose stocks have fallen from lofty heights, such as E*Trade ( ET), Akamai Technologies ( AKAM), Bisys Group ( BSG) and Quanta Services ( PWR).

Carlson says it could be a challenge this year matching the fund's average annual return of 11.5%. But, he adds, "Our bond side is pretty well protected against rising interest rates. We do well in bad markets."

Before joining, Ann Perry was the personal finance columnist for The San Diego Union-Tribune. She is the author of "The Wise Inheritor: A Guide to Managing, Investing and Enjoying Your Inheritance" (Broadway Books, 2003). She has a B.A. in English and Communications from Stanford University and a master's degree from the Columbia University School of Journalism. She can be reached at

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