How to Manage the Prospect of Higher Interest Rates

The Federal Reserve has made it clear that it is planning to raise interest rates this year if the economy continues to improve. This would be bad news for fixed rate bond funds, especially those with higher durations.

So if you think interest rates are going up, what do you do? Some advisors in the “buy and hold” camp say you should just build a diversified bond portfolio and hold it, and ignore  the up and down moves in the market. They feel that if interest rates rise, long term investors can reinvest coupon interest to buy more shares. When interest rates rise, the reinvestment yield goes up, and higher yields can partially compensate for the decline in share prices.

This approach can work for modest interest rate increases. But for large interest rate increases like occurred in the 1970’s, the capital losses would far exceed the higher interest earned. We may be nearing the end of a long term secular bull market in bonds that has lasted almost 30 years. If we enter a secular bear market in bonds, it may also last for many years.

I place myself more in the second camp, and believe that the best way to prepare for higher interest rates is to take active steps, and buy bonds that will be more resilient to interest rate increases.

One way to do this is to shift to bond funds with shorter maturities and lower duration. These funds would suffer much less if rates rise. But the current yield of these short-term bond funds is fairly low. You can buy short term bonds at Janus, Fidelity, Vanguard and many other mutual fund companies.

Perhaps the best strategy to use to protect against significantly higher interest rates is to purchase a bank loan mutual fund. These funds mainly invest in loans made to corporate borrowers that are below investment grade. The loans are adjustable, based off of floating rates and hold their value during periods of rising interest rates. For example, suppose the Federal Reserve were to raise the fed funds rate by 2 percentage points in the next year. The coupon on a 4 percent loan would most likely rise to about 6 percent.

Here are three of the better bank loan mutual funds that are worth taking a look at:

  Ticker YTD Return* 1-Year Return* 3-Year Return*
Eaton Vance Floating-Rate Advantage EIFAX 7.84% 44.02% 3.65%    
Fidelity Floating Rate FFRHX 3.82% 17.69% 3.91%    
MainStay Floating Rate MXFIX 4.44% 21.85% 2.95%    
             
* Morningstar returns as of 4/29/10            
             

The fund expense ratios are-    

EIFAX: 1.04%       FFRHX: 0.75%      MXFIX: 0.77%

Full Disclosure: Long FFRHX.

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