These are frustrating times for savers who seek interest income. Yields on money market funds are a microscopic 0.05%, while five-year Treasury bonds deliver a meager 2.35%. But richer payouts could be coming. Federal Reserve chairman 
Ben Bernanke has said that he is committed to raising rates as soon as the economy strengthens.

If the Federal Reserve lifts rates in the next year, as many economists expect, yields on bonds and money markets would likely climb. That would be good news for some savers. But investors in bonds and bond funds could be badly disappointed. When rates rise, prices of existing bonds can fall. This occurs because investors dump low-yielding veteran issues in favor of new bonds with higher yields. If rates rise by one percentage point this year, the value of the average intermediate-term bond fund would drop 4%.

Diversify bond holdings

How should you prepare for rising rates? Financial advisors suggest a 
variety of approaches. Zane Brown, fixed-income strategist for Lord Abbett, tells investors to diversify their port­folios, holding a mix of government and corporate issues, including high-quality and low-quality bonds. The idea is that bonds do not all move in lockstep. When rates rise, some issues collapse while others suffer little or no losses. By keeping a variety of holdings, you can cushion downturns. 

Continue Reading

The wisdom of diversification became clear in 2009. During that tumultuous year, rates rose on Treasury bonds. That spelled trouble for long government funds, which lost 17.5%. At the same time, high-yield funds—which 
own low-quality corporate bonds—soared 46.7%. 

Make no mistake: High-yield bonds are not likely to repeat their big gains any time soon. Still, Brown notes that high-yield bonds can add some juice to bond portfolios. Known as junk bonds, the high-yield securities are rated below investment grade. Junk prices often fall during periods when the economy is weakening and investors worry about defaults. When the economy is strengthening, junk prices rise as the risk of default recedes. That happened last year. And Brown believes that junk bonds will continue climbing in coming months, as the economic recovery gains steam. 

Some investors may prefer a fund that holds a mixture of junk bonds and high-quality issues. A top choice is Loomis Sayles Bond, which returned 8.5% annually during the past ten years. Loomis has a long history of delivering decent results in times of rising rates. 

Consider that the last big rate rise came in 1999, when yields on 10-year Treasuries climbed from 4.69% to 6.40%. For the year, the average intermediate-term bond fund lost 1.4%, whereas long-term funds dropped 2.7%. Meanwhile, Loomis Sayles managed to return 4.5%. 

Loomis achieves its results by focusing on undervalued bonds. The fund currently has 30% of its assets in junk bonds, including holdings in issues from Ford Motor Company. Portfolio manager Kathleen Gaffney includes high-quality bonds that are unlikely to default. Recently, she has been buying Canadian government bonds. A big exporter of commodities, Canada should thrive as growing economies in emerging markets import more oil and other supplies. 

Another option: bank loan funds

Another way to diversify is with bank loan funds, which currently yield 4.4%. These funds own loans that have been made to corporations. Because the loans are adjustable, their yields rise along with interest rates. Say the Federal Reserve raises rates by one percentage point. The yield on a 5% adjustable bank loan might rise to 6%. Owners of bank loan funds would collect the rising income—and suffer no principal losses.

One of the most conservative bank loan funds is Franklin Floating Rate, which has returned 2.6% annually during the past five years. Because Franklin invests in loans of relatively higher quality, it outdoes competitors during 
market downturns. 

Some advisors suggest protecting against rising rates by holding short-term securities. Bonds with maturities of three years or less tend to suffer only minor losses during periods of rising rates. To own short-term issues, consider FPA New Income Fund. While FPA portfolio manager Tom Atteberry is free to buy long bonds, he has shortened his holdings recently in anticipation of rising rates. Atteberry says huge borrowing by Washington will push up interest rates eventually. Rates will have to rise in order to persuade China and other countries to buy Treasury bonds.

To protect shareholders, Atteberry has taken extreme measures. He has stashed 23% of his assets in cash, an outsized position that will hold its value if rates rise. In addition, Atteberry has been focusing on securities with short maturities of two years or less. 

Taking a defensive position is nothing new for FPA. Atteberry’s aim is to avoid losing money during any year. By limiting the downside and producing decent results in bull markets, he tries to deliver strong long-term returns. 

Since the fund started in 1984, it has never suffered a losing year, an unmatched record. When credit markets collapsed in 2008, FPA shined, returning 4.3% in a year when its average competitor lost nearly 5%.

Hold through hard times

Yet despite Atteberry’s success, many reject his thinking. Instead, they say that investors should build diversified portfolios of varying maturities—and hold them long-term. Sticking to your guns means that you will suffer some losing years, the critics argue, but eventually the markets will rebound.

Vanguard Group urges investors to hold through the hard times and continually invest bond interest payments to buy more bonds. Fund shareholders who reinvest can profit from rising rates. 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. 

Whether or not you follow Vanguard’s approach, now is a good time to examine your bond portfolio and get ready for the day when rates rise. By developing a careful strategy, you can avoid panic and ensure that your investments deliver decent results in up and 
down markets. n