How 'Non-Vanilla' Bonds Can Fend Off A Fed Rate Hike

NEW YORK (MainStreet) –- Rising rates are about to make bonds and other fixed-income investments a whole lot less conservative, which means there's money to be made if you play it the right way.

With Federal Reserve Chair Janet Yellen guaranteeing a rate hike in the near future, investors should prepare to see the price of long-term bond mutual funds and ETFs decline in response.

“Generally speaking, the volatility inherent in fixed income is traditionally not as severe as in equity markets,” says John Diehl, senior vice president of strategic markets at Hartford Funds. “The bigger issue is that our expectations have shifted to a place where we may not even suspect that our fixed income assets may lose value. For the longer term, we need to check our perspective to reacquaint ourselves with the role that fixed income plays in our portfolios. It may be a source of stability or liquidity.”

Rising interest rates would cause the value of long- and intermediate-term bond funds to plummet, says Thomas Walsh, an investment analyst in Palisades Hudson Financial Group’s Atlanta office. However, there's still plenty of opportunity for income in shorter-term, floating rate, and inflation indexed bonds.

“With most of your fixed-income portfolio, KISS -- Keep It Short and Simple,” he says.

Walsh advises that investors place at least 60% of their fixed-income portfolio in short-term certificates of deposits, money market funds and high-quality short-term bond funds with an average maturity of about two years or less. If you're in one of the higher tax brackets, you can use short-term tax-free funds.

“Asset allocation remains a driving factor in overall return,” Diehl says. “You and your advisor may choose to make opportunistic shifts in various fixed income sectors, but timing the fixed income markets is as inadvisable as timing equity markets. A better approach may be to make sure that you are adequately diversified within the fixed income allocation in your portfolio."

In Walsh's view, that involves investing in alternatives to basic short-term funds. If you can take a bit more risk -- and that's the most important caveat -- Walsh advises investing up to 40% of your fixed-income portfolio in “non-vanilla” income funds.

“They generally pay higher yields and are well-positioned to keep their value when rates rise, which is bound to happen in the near future,” Walsh says.

If you can manage the risk, a “non-vanilla” income fund can reduce some of the blunting effects of a Fed rate hike. Walsh notes that there are three particular flavors of the "non-vanilla" fund spectrum you should consider:

Merger arbitrage funds. Up to 10% of your fixed-income investment can go into a merger-arbitrage mutual fund, a stock fund with nearly bond-like performance. The fund buys shares of merger acquisition targets at a slight discount to the expected value upon completion of the deal. This price difference is known as the arbitrage “spread” and is captured as long as the deal is completed. The manager buys protection in case the deal falls through.

“It’s a concept with a solid long-term record,” Walsh says.

Inflation-managed bond funds Walsh advises allocating 10% to 15% to these hybrid funds, which include inflation swaps along with short-term fixed-income holdings. An inflation swap involves one party paying a fixed rate on the swap amount in exchange for a floating-rate payment based on actual inflation.

“These funds are an effective way to mitigate the effects of inflation while keeping interest-rate risk low,” Walsh says.

Floating-rate bond funds—also known as bank-loan funds Finally Walsh suggests dedicating another 10% to 15% out of the larger 40% to these funds, which purchase loans made by banks to companies with below-investment-grade credit ratings. The underlying loans’ yields float, generally rising with broader market rates, protecting investors from most interest-rate risk.

Unlike high-yield junk bonds (which Walsh says are generally too risky), floating-rate loans have safeguards built in, including collateral, performance-based covenants and a senior debt position. Senior debt is more likely than other debt to be repaid in case of a bankruptcy.

“Look for a conservatively managed floating-rate fund instead of trying to find the highest yield,” Walsh says.

All that said, there is no one-size-fits-all strategy for fixed-income investing. Walsh notes that his plan isn't the only option and that any plan should be tailored to an individual portfolio based on your risk tolerance, liquidity needs, investment horizon and personal goals. Walsh's colleague, Benjamin Sullivan, a certified financial planner and portfolio manager with Palisades Hudson's Scarsdale, N.Y. office, notes that investors who have stocked up on cash, short-term bond funds and floating-rate bond funds should welcome interest rate hikes, since they'll earn decent income on their investments. 

“The Fed will continue to have its foot on the gas pedal for the foreseeable future, since they plan to only gradually increase interest rates from zero,” Sullivan says. “Just because the Fed is raising interest rates doesn’t mean that it will be a drag on the economy if rates are still low in absolute terms.”

However, Walsh suggests that investors remember that the primary purpose of fixed-income investments is to reduce the volatility of the total portfolio. Those investments are there to preserve your wealth, not gamble it, so be prepared to be ecstatic about breaking even.

“As ever in times of flux, there will be significant opportunities, as well as challenges, but the opportunities will be actively sought with a fresh different approach and outlook,” says Nigel Green, founder and chief executive of the U.K.-based deVere Group. “Investors are likely to need to accept lower returns in this new era.”

This article is commentary by an independent contributor. At the time of publication, the author held TK positions in the stocks mentioned.

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