Bond Strategies For a Rising Rate Environment

For the most part, bond investors have had a very nice, very long run.

Continue Reading Below

Interest rates had been in a falling pattern for 30 years, and that meant solid gains for anyone who bought big yields and then held onto them while new securities offered lesser rates of return. ”If you were a little kid and hopped on the bond slide in 1981, you would have had a pretty fun ride until 2010,” said Steve Huxley, chief investment strategist of Asset Dedication, an investment research firm.

That ride may have ended in August of 2010, when yields bottomed out and started to rise. The yield on 10-year Treasuries hit 2.52% then; now they are trading at 3.61%. As the economy strengthens and inflation rises, interest rates could be entering a long upward trajectory. That leaves income-oriented investors unsure of how to collect the benefits of bonds while protecting themselves from a rout.

“There’s a good chance that the time bomb in bond funds will go off,” says Asset Dedication president Brent Burns, who recommends individual bonds instead of funds. “Rates are either going to stay flat, or they could rise again. In either situation, bond funds are not a good investment choice.”

That’s because bond fund prices fall as interest rates rise, and there’s never a date certain when a fund’s value (and the investor’s principal) are certain to regain their original level. Individual bonds, on the other hand, present a specific income stream and a date certain when the bond can be sold for its face value, says Burns. He tells investors to match the maturities of the bonds they are buying with the time horizons in which they will need the money from those bonds.

But Jeff Tjornehoj at Lipper Inc., a Thomson Reuters company, has a different point of view. He is not persuaded that sticking to individual bonds offers much more protection from losses than do funds. “If you need to draw on your bond allocation at an inappropriate time in a rising-rate environment, you will take a capital loss on your individual bond,” he said.

Furthermore, Tjornehoj has looked at the performance of bond funds and found them far less affected by rising rates than might be expected. He looked at various periods in which rates rose and discovered that in most cases, the rising yields captured by the funds made up for the falling prices in short order. In fact, between January 2009 and April 2010, yields on 10-year Treasuries went from 2.13% to 3.86%. During that same time, the total return of intermediate-maturity investment-grade bond funds was an eye-popping 16.95%.

In the worst rising rate environment he studied, “a terrible time” from October 1993 to December 1994, those 10-year Treasury yields went from 5.35% to 7.85%, and the funds lost 3.98%. But by March of 1995, four months later, they had regained all of their lost principal.

So choosing indie bonds instead of funds may or may not help, but it isn’t the secret to winning in today’s bond market. Here are some other strategies that can help you navigate now.Go corporate. Tjornehoj notes that the spreads between Treasury bonds and corporate bonds narrowed during some of those rising rate times. When Treasury rates pop up, corporations will sometimes hold the line on their borrowing costs and try to keep rates from rising in tandem. Furthermore, bond traders recently have been more worried about government debt than corporate debt. That leaves corporate bonds with a little bit more breathing space to raise rates slowly or hold them flat, protecting the prices of the bonds.

Don’t wait. Whether you’re buying funds or individual bonds, it doesn’t make sense to wait until bond yields have soared before committing your money, say Huxley and Burns. “Market timing is a dangerous sport for fixed income as well as for equities,” they concluded in a study of several different investment approaches, all involving investors holding money for two years before committing it to bonds when rates were rising. Their bottom line? “There is less than a 40% probability that even the best waiting strategy would be better than buying now.”Diversify. Especially if you’re investing in corporate bonds, it’s too dangerous to just focus on the bonds of one company or cluster all of your purchases around one maturity period. That’s where mutual funds and exchange traded funds can help; one purchase can give you broad diversification. But if you prefer individual bonds and are buying them instead of funds, you may be able to buy fewer than you think. It can take as few as ten distinct bonds to offer most of the diversification benefits of a full fund, according to a study by researchers at the BondDesk Group.

Hedge those bond bets. The big threat is that inflation and interest rates will take off and beat up your bonds, says Tom Samuelson, the chief investment officer at Advanced Equities Asset Management, a San Diego money management firm. Very long term 30-year bonds have already given up almost 15% in value since rates bottomed out in August, 2010, he says, suggesting they could fall another 9% this year. To protect bond portfolio against something like that happening, Samuelson suggests investors hedge against inflation by buying commodities and foreign bonds. He also suggests that investors shorten the maturities of their bond portfolios. The shorter the maturity of the bonds, the less jarring any rise in rates would be.