Inflation-Proof Your Bond Fund Investment

Dear Dr. Don,

I recently read an article that warned long-term bond funds with a high duration of 10 to 14 years will be adversely affected by rising interest rates. Since rates are at rock bottom, they can only go up from here, right?

Would intermediate-term bond funds be safe? I'm wondering about one with a duration of five years and a short-term bond fund with a duration of only two years. I see that the money market fund in my 401(k) is made up mostly of U.S. government notes and bills. How would they fare if interest rates rise?

Thanks, -Chris Conundrum

Dear Chris,

As you note, with interest rates at or near historic lows, it'll be virtually impossible for them to go any lower. That has many experts predicting the end of the bull market in bonds.

Fixed-rate mortgages have historically been priced based on the yield of the 10-year U.S. Treasury note. That security was at a low yield of about 1.5% last summer. It was yielding about 2% in early 2013. While that's just one-half of 1%, it is a 33% increase over last summer's yield. The change in long-term yields is driven in large part by market-based inflation expectations. The Federal Reserve has kept short-term money cheap and available. That liquidity is supposed to help the U.S. economy. Even so, the economy is experiencing low growth and little inflation. If growth and inflation heat up, yields would be expected to rise.

When interest rates go up, bond prices go down. Shortening duration of your bond portfolio reduces its price risk.

Duration is considered a better measure of a bond's risk than maturity because it considers the entire cash flow stream of a bond, not just the bond's final maturity. Short duration bond funds have less price risk than long duration funds in a rising interest rate environment.

Investopedia defines duration as "a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices."

If your 401(k) plan's money market fund is invested in U.S. Treasury securities, that reduces default risk, not price risk. That price risk is reduced by the short average maturity of the money market securities held by the fund.

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