Hunkering down for rising interest rates

(Money Magazine) -- Question: I'm 65, retired and have about 50% of my portfolio in a bond index fund. I'm thinking of switching to a short-term bond fund. Do you think that's a good idea? --Judy, Flowery Branch, Georgia

Answer: I assume you're thinking of moving to a short-term bond fund because, like many investors today, you're worried that interest rates might soon climb.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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That fear is hardly unfounded. Rates have been at or near historic lows for a while now. And although inflation appears dormant at the moment, it could re-awaken as the economic recovery and the effects of all that federal fiscal spending kick in, sending rates upward. So it seems reasonable that interest rates are more likely to go up rather than down from here.

And we all know what happens to bond prices when rates rise. They fall because the price of bonds and interest rates are like opposite ends of a seesaw. When one goes up, the other goes down. And the longer the seesaw -- i.e., the longer the maturity of the bond -- the bigger the swing in prices.

So if you think rates are going to rise, you want to be toward the shorter end of the maturity spectrum to protect yourself against possible losses. And if you think rates will fall, you want to be toward the longer end.

Problem is, forecasting ups and downs in interest rates is like predicting movements in the stock market -- a lot easier said than done. So while I think it's safe to say that most people expect rates to rise from here, no one can say with much certitude when that will happen and, assuming it does, how much higher rates will go and how much the increase might vary for bonds of different maturities.

Faced with such uncertainty, investors have two choices. One is to try to navigate fluctuating rates as best you can by moving into shorter-term bonds when you think rates might climb and into longer bonds when you think they might drop.

But if you think you can pull that off successfully on a consistent basis, I recommend you go into the bond management biz. You'll shine, because most bond managers aren't particularly good at it.

The other option -- the one that I think makes sense for individual investors -- is to own a bond portfolio that has an average maturity long enough to provide decent income over the long run but not so long that you'll get hammered when rates rise.

One way to assess your risk of getting clobbered is to look at a bond fund's duration. I'll skip the technical mumbo jumbo and just say that duration gives you a good idea of how sensitive a bond or bond fund is to movements in interest rates. The longer its duration, the more its value will fall when rates rise and rise when rates fall. To find a bond fund's duration, plug its ticker symbol into the Quotes box at Morningstar.com and then click on the Portfolio tab.

Clearly, the acceptable tradeoff between risk and return will vary from individual to individual. But for most people, retired or not, I think a reasonable starting point is to consider a total bond market index fund as their core bond holding.

When you own such a fund, you're basically getting the entire investment-grade taxable bond market -- Treasuries, mortgage-backed bonds and investment-grade corporate issues -- in one fund. Today, such a fund would have a duration of just over four years, meaning if interest rates rise one percentage point, the price of the fund would drop by a bit more than 4%.

You can get more protection from price declines by going to a short-term bond fund. A short-term bond index fund that limits itself to the shorter end of the investment-grade taxable bond market fund has a duration today of just under three years. So a one percentage point increase in rates would send the price of the fund down less than 3%.

Remember, though, you're also getting interest payments from a bond fund. And that income will provide a bit of a cushion against the price hit the fund takes. So you'll do better on a total return basis -- i.e., when you combine the change in your fund's price with the income it pays -- than if you look only at the price loss due rising rates.

How much better? To see, I asked Vanguard to crunch the numbers for two of its funds -- the Total Bond Market Index (BND) fund and the Short-term Bond Market Index (VBISX) fund. After factoring in the income the Total Bond Market Index fund would pay over the course of a year, Vanguard estimates it would have a total return loss of about 1.5% should rates rise by one percentage point over the course of 12 months. The short-term bond index, by contrast, would have a total return loss of just under 1%.

There are two things to keep in mind, though. First, this is a hypothetical example based on conditions in the bond market today. It's not a prediction of what will unfold.

Second, this example assumes rates increase by one percentage point for both funds. In reality, interest rates can change by different amounts for different maturities of bonds. Indeed, with short-term rates so low due to the Fed's efforts to spur the economy, some observers believe rates could climb more at the short end of the maturity spectrum than at the long end, which would give the short-term bond fund a larger price and total return loss than indicated above.

That said, over the long term you'll generally gain more protection on both a price and total return basis by going to a shorter-term bond fund than one with a longer term.

This suggests to me that, unless you're confident about your ability to discern the various cross currents of the bond market, a total bond market index fund is a good core holding for the money you intend to devote to bonds. You'll get a nice blend of return and protection against truly disruptive losses.

If you want to shoot for a higher long-term return and are willing to accept more risk, you could always put some dough into a longer-term bond fund with a longer duration. And if you're willing to accept a slightly lower long-term return in return for less volatility, then you can complement your total bond market fund with a shorter-term bond fund that has a shorter duration.

You can also diversify further into other categories of bonds. But I don't think there's anything wrong with keeping things simple.

One final note: Whatever tradeoff between maturity and yield you decide is right for you, don't forget to factor in expenses as well. Over the long run bond fund returns tend to average in the single digits. And given today's low yields, we may be looking at long-term returns in the mid-to-low single digits.

So stick to funds with below-average expenses.

Bond index funds clearly fit the bill on that score, although if you go to our Money 70 list of recommended funds, you can also find actively managed bond funds with reasonable charges.

If nothing else, the extra yield you'll pocket by limiting yourself to bond funds with low expenses might also give you a little extra cushion against rising interest rates.

Money magazine is looking for Detroit families (including people who have recently moved away) who are willing to discuss their finances and are looking for financial advice. If interested, email your contact information to gmannes@moneymail.com.