Where to put your bond money in a rising-rate environment.
By David Kathman, CFA, Ph.D. | 08-18-04 | 06:00 AM | Email Article

Dear Analyst,

As interest rates rise, bonds fall. Is there anything in the nature of bond funds that enables one to "ride out" the interest rate problem?

David Kathman, CFA, Ph.D., is a senior manager research analyst for Morningstar.

Ken

Now that the Fed has finally started to raise interest rates, a lot of people are concerned about the issue raised by Ken's question. In fact, they've been concerned about it for quite a while, because rates have been so low for so long, everybody knew the Fed would eventually have to start tightening. Nearly a year and a half ago in this very column, my colleague Brian Lund answered a similar question by giving a very thorough overview of the factors that make bonds more or less sensitive to rising rates.

More recently, there's been plenty of talk about specifically which bond funds, or groups of bond funds, are likely to best weather the storm of rising interest rates. Back in March, senior fund analyst Eric Jacobson tackled this subject in a Bond Squad column, and we've also heard from lots of bond fund managers about how they're handling the situation. But it's worth revisiting the topic now that rates have finally started to creep upward again, and we can see how various funds are doing so far.

Duration, Duration, Duration
The most obvious way to guard against rising rates is to focus on bonds (and bond funds) with low duration, because duration measures how sensitive a bond is to changes in interest rates. Low-duration bonds don't fall as much when rates rise as higher-duration bonds do, at least in theory. But low-duration bonds also don't gain as much when rates fall, so this strategy is something of a double-edged sword. Also, if investors pile into short-term bonds in anticipation of a rate hike, those bonds can get expensive, making them less attractive.

That's what has happened in this year's up-and-down bond market: Short-term and ultrashort bond funds have actually been among the worst-performing of all fixed-income categories. Longer-term bond funds, on the other hand, have held up surprisingly well, with the long-government category ranking as the best-performing bond-fund category for the year to date through Aug. 13 (and the long-term bond category is not far behind). Long-term bonds did take a substantial hit when rates first spiked in March, but they've since rallied after the Fed did not raise rates as aggressively as some people had feared.

A middle ground consists of intermediate-term bond funds that have shortened their duration in anticipation of rising rates. A good example is  FPA New Income , run by former Morningstar Fixed-Income Manager of the Year Bob Rodriguez. Rodriguez has been expecting higher rates since last year, and he has accordingly taken his fund's duration down into short-term territory, far below the intermediate-bond average. That has helped the fund achieve one of the category's best records this year, to go with its fine long-term returns. That positioning helped the fund weather the rising-rate storm in March and April but has held it back in recent months.

Other Options
If we start looking beyond duration, another group that tends to do well in rising-rate environments is bank-loan funds. The loans held by these funds have floating interest rates that are reset every 90 days based on LIBOR (the London Interbank Offered Rate). They're thus insulated from the interest-rate risk that bedevils other bond funds, though they can still carry quite a bit of credit risk.

The bank-loan category was one of the best-performing bond-fund categories through the first half of this year, though it has fallen off a bit in recent weeks. Our two Analyst Picks in the category,  Eaton Vance Floating Rate and  Fidelity Floating Rate High Income , are both fine choices for investors seeking exposure to this niche, and the Fidelity fund is the only no-load option in the category.

Another category that has traditionally weathered rising interest rates well is high-yield bonds. These bonds have such high yields already that they're not likely to be dramatically affected by a quarter-point change in the Federal funds rate; instead, the credit quality of the bond's issuer is the key factor. Signs of a strengthening U.S. economy have helped the high-yield category to one of this year's best returns among bond-fund categories, even after a bang-up 2003 made the group rather expensive in many people's eyes.

Among our favorite high-yield funds are  Eaton Vance Income Fund of Boston , whose nimble style has helped it build an excellent long-term record, and  Northeast Investors , which has thrived this year with one of the high-yield category's best returns. Both are Analyst Picks, but both also carry a considerable amount of credit risk. Although they're likely to be less sensitive to rising interest rates, they're subject to plenty of other risks and are not for the faint-hearted.

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David Kathman, CFA, Ph.D. does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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