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I'm 66 years old and have 60 percent of my portfolio in stock index funds and 40 percent in a short-term bond index fund. I'm concerned, though, that rising interest rates will reduce the value of my bond shares. Is there a better choice than a short-term bond fund for the income portion of my portfolio?
-- L. Freeman, Dallas, Texas
Your concern about the effects of rising interest rates on a bond portfolio's value is one that's shared by thousands, nay, millions of your bond investor compatriots throughout the land. Even well-known bond gurus like Bill Gross, who manages billions in bond money for the fund-and-institutional money management firm PIMCO, has been bearish about the outlook for bonds.
And it's a legitimate concern. If interest rates rise, the prices of most bonds will take a hit -- some a bigger hit than others -- and many investors who fled to bonds for safety after stocks hit the fan back in 2000 will realize that even staid old boring bonds can have their exciting side, if you consider possible loss of principal exciting.
So, what to do?
Well, you would certainly lower your exposure to interest-rate risk by moving your bond holdings into money-market funds since their principal value, for all practical purposes, is immune to rising rates.
But it's not as if such a move has no downside. While you're sitting in a money fund, you would be receiving a lower rate of interest than you'd be getting in your short-term bond fund. That wouldn't be a problem if rates began rising sometime soon, since you'd be compensated by keeping your principal whole vs. losing some in the bond fund. But what if rates don't take off anytime soon? Or if they climb only a little bit?
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I know that seems unlikely since the economic recovery appears to be (finally) taking hold. But who knows, maybe there won't be enough oomph to push rates up very high, and maybe Alan Greenspan at the Fed won't be too eager to push rates up very quickly given the tenor of the economy.
In short, there's always the chance that you'll move to money funds too soon or that the move won't pay off very much. And you would also have the decision of when to get back into your bond fund. My feeling is that most individuals aren't good at making such calls, which, to me, argues for not trying to get fancy and move back and forth between money funds and bond funds.
The other option -- which I think is the better one -- is to pick a bond fund or group of bond funds that have relatively low interest-rate risk and hang in (rebalancing your portfolio once a year, of course, to restore your original stocks-bonds mix).
Yes, your bond portfolio's value will take a hit if rates rise. But by being careful in your selection of bond funds and realizing what magnitude of interest-rate risk you're taking on, you can then manage the extent of the hit.
Assessing the risks
The primary tool for gauging interest-rate risk in a bond or bond fund is a measure known as duration. I don't want to put us both to sleep by going into the complicated technical aspects of this concept, so I'll just say that duration provides an easy-to-use gauge for measuring how much a bond or bond funds' value will rise or fall in response to interest rate changes.
The higher a bond's duration, the more its value will drop if rates rise and the higher its value will climb if rates fall.
So, for example, the Vanguard Short-term Bond Index fund -- which holds Treasuries, other government and corporate bonds -- has a duration of about 2.4 years. That means if interest rates climb one percentage point, the value of the fund's holdings would fall roughly 2.4 percent. Add back the interest payments the fund collects from the bonds it owns, and you're probably talking a wash, or close to it.
If rates were to climb two percentage points, however, then we'd be talking about a price hit of about 4.8 percent and probably a loss for the year. (I'm not predicting rates will rise one or two percentage points; I'm just showing how duration works.)
You can get the duration for a bond fund by inserting its ticker symbol into the "Get a Quote" box that appears at the top of virtually every page of our Web site. That will bring you to a Morningstar Snapshot Report for your fund. You then just click on the "Portfolio" link near the top of the page and voila! You'll get the fund's duration as well as an average credit rating of the bonds in the portfolio.
In short, you'll see just how vulnerable your fund is to rising rates. As interest-rate risk goes, a duration of less than three years or less is pretty low. The Vanguard Long-term Bond index fund, by contrast, has a duration of about 10.9 years, while American Century Target Maturity 2025, a fund that holds zero-coupon bonds that, as its name implies, mature in 2025 fund, has a duration of just under 24 years.
About the mix...
Now, I would be perfectly comfortable sticking to the 60-40 mix you've settled on. If, on the other hand, you're feeling a bit anxious and would like to make some changes, there are a few things you could consider.
For one, you could put a small portion of your bond holdings into a short-term bond fund that specializes in short-term corporate bonds. The reason is that corporate bonds tend to have both higher yields and lower durations than Treasury bonds of the same maturity.
So you may be able to find a short-term corporate fund that has a higher yield and lower duration than a short-term index fund that includes both Treasuries and corporates. Which means the corporate bond would hold up slightly better in the face of rising rates.
Similarly, you could consider moving a bit of your bond money into a high-yield corporate bond fund, or, to put it less euphemistically, a junk bond fund. Yes, that would subject you to more credit risk, i.e., the chance of a bond defaulting or the fund taking a hit if the economy sags badly. But that's the point of owning high-yield bonds in a fund; you're diversifying default risk.
As for the economy taking a marked turn south, I don't think that's a very big risk at the moment. And if it did happen, interest rates would presumably stay flat or even fall, which would be good for the rest of your bond holdings. A high-yield fund would likely have a higher duration than your short-term index fund, but it would also have a higher yield as well.
In fact, it's perfectly possible that the yield might be high enough to offset any principal loss due to rising rates. Which is another way of saying that high-yield bond funds tend to do better than other bond funds during periods of rising rates.
Mind you, I'm not talking about a radical restructuring of your portfolio, but tinkering around the edges -- and even then only if you're feeling particularly anxious about your basic 60-40 mix.
By the way, Bill Gross at PIMCO recently told us here at CNN/Money what he's been doing with his own portfolio in light of his outlook for the bond market. If you'd like to see the moves he's been making, click here. But remember, kids, Bill Gross is a professional. So you may want to be careful before you try any of his strategies at home.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Mondays.
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