Prepare Your Portfolio for Rising Interest Rates

You've been warned -- for years -- about the impact of rising interest rates on bonds and what that might do to your portfolio.

The impact is already being felt, and the Federal Reserve hasn't even done anything yet. Long-term government bond funds are down 13% year to date through Sept. 9, according to Morningstar. The selloff is due to investors' expectations that the Federal Reserve will begin tapering back from its bond-buying program as the U.S. economy shows signs of improvement. Now the specter of rising interest rates is looming large, even though the Fed isn't expected to actually raise the federal funds rate until 2015.

Overall, bonds have shed 3.4% of their value, as measured by the Barclays U.S. Aggregate Bond Index, which tracks a blend of corporate and government bonds. That's a big decline in the history of the bond market, but only a drop in the bucket compared to the types of losses that the stock market can inflict in a New York minute.

Bonds are supposed to serve as the ballast in an investment portfolio, steadying the ship in times of stock market storms. But these fixed-income investments -- particularly long-term Treasury bonds or mutual funds that invest in them -- can rock the boat when interest rates rise.

There's simple math involved in bond movements. Without getting in too deep, here's the rule of thumb: "It's a rough estimate, but I think it's easy to remember," says Donald Cummings, founder and portfolio manager of Blue Haven Capital in Geneva, Ill. "If their bond portfolio is an average of 10 years in maturity, then (investors) will see a 10% price drop with a 1% rise in rates."

How bonds work

The price of bonds moves in the opposite direction of yield. When interest rates rise, prices of existing bonds go down.

Very long-term bonds, such as 10 years or longer, are the most impacted by rising rates. Experts recommend that investors steer clear of very long maturities until rates move up.

In general, a person who owns individual bonds likely will be better off than someone invested in bond funds in the short run. That's because individual bonds can be held until they mature, at which point the investor will receive the face value.

On the other hand, a bond fund might not be able to hold every bond until it matures because it might have to meet redemptions due to investors' demands to sell their fund shares. This means that the price of the fund will take a bigger hit in the short term than a portfolio of comparable, individually owned bonds.

Should you sell all your bonds?

Trying to dump bonds before an interest rate increase is a lot like trying to time the stock market. Dumping all your stocks to avoid uncertainty and short-term pain wouldn't make any sense, either. The same is true with the fixed-income side of your portfolio. Instead of fleeing bonds altogether, investors can take steps to diminish the impact of rising rates by moving to investments with shorter maturities.

Fixed income investors with some flexibility in their income needs "should simply shorten their portfolio," says Cummings. By that he means investors should purchase short-term bonds, which will take less of a hit on price than longer term bonds.

It's trickier for investors with less flexibility around the income received from investments. They could, in that case, sell their bonds with a low coupon (interest) payment and buy a bond with a higher coupon with the same yield.

To do that, investors would have to pay a little bit more, or a premium, for a bond issued years before their current bond was issued -- back when interest rates were higher. The market determines the size of the premium based on how much money newly issued bonds yield.

For example, in the table below, two bonds mature in 20 years, but the one that was issued 10 years ago has a higher yield and payout.

If someone wants to buy the first bond today on the secondary market, "The market would pay enough to obtain approximately 4% yield to maturity -- which in this case might be something like 120 cents on the dollar," says Cummings.

The table below shows the purchase price is higher for the older bond with the higher coupon payment, which makes the overall return on the bond commensurate with that of the bond with the lower yield and smaller coupon payment. If it costs more and has the same yield to maturity, what makes the older bond more desirable? The current yield is greater. That's calculated by dividing the yearly coupon payment by the purchase price. So, $600 divided by $12,000 equals 5%.

Plus the older bond can be less volatile. The higher coupon payment will cushion the impact of rising rates, which means the investor takes less of a hit on price.

"The 4% coupon bond might lose 15% in value if rates go up 1%, whereas the 6% coupon bond might only lose 10% in value," Cummings says. In this case, investors would pay a little bit more upfront, receive a higher payment and get less volatility in their portfolio.

Take a trip abroad for bonds

Many investing experts tout the importance of global diversification in today's connected world. But international diversification isn't just for stocks.

"Too many investors are overlooking the importance of global bonds in their portfolio," says Peter Lazaroff, CFA, CFP professional and portfolio manager at Acropolis Investment Management in St. Louis. "International bonds are exposed to different interest rate and inflation fluctuations, the two biggest drivers of bond returns, as well as varying economic cycles and political regimes."

For the more risk-tolerant, global high yield and emerging-market corporate bonds offer the chance to go off the beaten path -- and those are areas where investors "can pick up some nice yield," says Amy Magnotta, CFA, portfolio manager and senior investment manager at Brinker Capital in Berwyn, Pa.

"You want an active manager to be picking those credits," she says. "Using an (exchange-traded fund) or index, it can be a little bit dicey, so you want to make sure you have someone doing credit research."

Having an expert sift through the investment choices in less liquid or smaller markets sometimes helps performance. That could come in handy as the world adjusts to higher rates in the U.S.

Calling in expert help could be useful for individuals as well. If the thought of figuring out bond durations and premiums versus par seems too daunting, consider visiting a fee-only financial planner or adviser. Investment planning is a full-time job for a reason. It can be complicated.