Emphasizing sectors that are less rate-sensitive. Some sectors of the bond market have historically been less sensitive to rising interest rates than others. Government agency bonds such as GNMAs, for example, tend to feel less of a pinch from rising interest rates than Treasury bonds or high-quality corporate issues. When interest rates rise, the combination of high yield and lower prepayment risk makes them more attractive to investors, says Daniel Wiener, editor of the Independent Adviser for Vanguard Investors.
Wiener points out that between July 1999 and January 2001, a time of rising interest rates, the return of the group's GNMA funds surpassed that of almost all of Vanguard's other income funds except the long-term Treasury funds, which benefited from the government's unprecedented buyback program.
Another "buy" on Wiener's list is the group's high-yield corporate bond fund. Like some other market observers, Wiener believes that high-yield bonds were oversold last year. But with signs of an economic recovery, and an improvement in corporate balance sheets, junk bonds have become less dicey. The focus on improving credit quality should help overshadow the possible impact of rising interest rates. Funds making his sell list, those most susceptible to price erosion from rising interest rates, invest in high-quality, long-term securities, and include Vanguard's Long-Term Treasury, Long-Term Corporate and Long-Term Bond Index funds.
Cutting bond allocations and shortening duration. Scott Kays, a CFP licensee with Kays Financial Advisory Corp. in Atlanta, has gradually shaved the bond side of his portfolios over the last few years. Three years ago, his bond allocation targets for conservative, moderate and aggressive portfolios were 60%, 40% and 25% of assets, respectively. Now, they are 40%, 20% and zero. "I expect interest rates and inflation to tick up over the next year or two," he says of the reason behind the changes. "And I think that stocks are undervalued relative to bonds right now."
Kays has also moved most fixed-income assets into short-duration bond funds, including PIMCO Low Duration and PIMCO Total Return. Using a combination of these funds, his fixed-income portfolios achieve an average duration of about three years.
Hedging with funds that bet on rising rates. To hedge some of his clients' long-term bond fund positions, Street uses the ProFunds Rising Rates Opportunity Fund, which is designed to track 125% of the inverse daily price movement of long-term Treasury bonds. If the yield on 30-year Treasury bonds rises and their prices fall by one %, the fund's net asset value should increase by 1.25 %. Of course, the fund's net asset value falls in the same proportion when bond prices rise. A fund with a similar objective, Rydex Juno, uses options and futures to provide total returns that inversely correlate to the daily price movement of the 30-year Treasury bond. Both funds can be used by hedgers like Street who want to protect long-term bond holdings, or by speculators who want to profit from rising interest rates.