Super-low interest rates will eventually rise, and when they do, bond investors could be stuck with losses.
It's a warning that's been heard frequently in recent years. Often, it's coupled with a reminder of the huge amount of cash — more than $1 trillion — that bond mutual funds have attracted in the past five years.
Warnings about rising interest rates have become louder in 2013, partly due to a spike in rates during the first couple weeks of the year. Consider this one: The prospect of higher rates "is looming ever-closer" says Art Steinmetz, chief investment officer at OppenheimerFunds, who describes a rate increase as "a dust storm that we're going to run into one of these days."
Although Steinmetz isn't predicting when a sustained rise will occur, he expects many investors will be surprised at how quickly bond funds can begin posting losses, especially if they hold plenty of lower-yielding Treasurys. Initial signs of a steady rise in interest rates could lead bond investors to sell. That would cause yields to suddenly climb and prices to drop.
Plenty of renowned investors have incorrectly predicted rates would be much higher by now. Yet there are some troubling signs. The yield on the 10-year Treasury note climbed to 1.90 percent on Thursday. That's the highest in eight months, and up from 1.70 percent at the start of the year. Mortgage rates also ticked up this week.
Interest rates remain historically low, but even a small increase like this year's climb in Treasury yields can have a big impact on fund returns. In fact, five of the 14 taxable bond fund categories that Morningstar tracks are down this year, with losses of as much as 2 percent.
A mutual fund's returns will vary because the manager must continually reinvest as bonds mature. This year's small rise in Treasury yields means previously issued bonds, which pay a lower interest rate, are now worth less. A fund with too much invested in those older bonds can end up with losses. That's because a fund's return is a function of bond price changes as well as the yield, or interest payments, that bonds generate.
It's important to keep perspective. While investors should be mindful of rate risks, the Federal Reserve has committed to keep borrowing costs low as long as unemployment remains high. That means a sharp rate increase is unlikely in the short term. However, the Fed could begin to push rates higher if the pace of economic recovery picks up, and inflation rises above its current 2 percent.
With inflation risks in mind, last week star bond trader Bill Gross, manager of the world's largest mutual fund, Pimco Total Return, offered advice in a commentary to investors: "You should avoid (long-term bonds), and confine your maturities and bond durations to short/intermediate targets supported by Fed policies."
Long-term bonds are generally defined as those that mature, or pay back principal, over six years or longer. A better option, he says, are short-term bonds that generally mature in less than three-and-a-half years, and intermediate-term bonds maturing in less than six.
The shorter the average maturity duration of bonds in the portfolio, the less vulnerable the fund will be to rising rates.
Morningstar bond fund analyst Michelle Canavan has identified four bond funds that offer strong potential to avoid losses when rates rise. Each fund has an average portfolio duration that's below the average of its peers. Each also possesses strengths that earned the fund either a silver- or bronze medal rating from Morningstar analysts. Those ratings are a subjective system that attempts to gauge a fund's performance prospects, not just its past record. The scale runs from gold to silver, bronze, neutral and negative.
The four funds:
1. JANUS SHORT-TERM BOND (JSHAX)
The average duration of this fund's portfolio is about two years, in line with the average of the short-term bond fund category. Its managers tend to favor corporate bonds while many funds in the category lean toward government bonds. This preference introduces more credit risk from potential defaults, but can also help boost the fund's yield and returns over the long run.
2. PIMCO UNCONSTRAINED BOND (PUBAX)
This fund is in Morningstar's nontraditional bond category and employs a complex strategy using derivatives, such as swaps and futures, to help offset rate risks and reduce volatility. The approach produces a low average duration that's often slightly negative, known as a "short" position. The fund's duration was recently negative 0.4 years, providing ample protection against higher rates.
3. FPA NEW INCOME (FPNIX)
This low-cost fund is also in the nontraditional bond category and it seeks to deliver modestly positive returns after inflation. In fact, it hasn't posted a loss in any year since 1984. Its average duration was recently 1.4 years.
4. OSTERWEIS STRATEGIC INCOME (OSTIX)
This multisector bond fund emphasizes bonds with low durations to protect against rate risks. It recently had an average duration of 2.3 years, about half the average for its category. Its focus on high-yielding corporate bonds helps keep yields high, while its emphasis on short-term durations limits risks from rising rates.
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