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What’s a bond investor to do in era of rising rates?

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Bond funds and individual bonds have not done well this year. Many investment advisers have consistently urged clients to maintain a common stock/bond ratio of 60/40.

Some recommend that retirees adjust the percentage of their portfolio invested in bonds to match their age. For example, hold 65 percent in bonds if you are 65, 70 percent if you are 70. Up until this year, investors who followed this advice would have done well. In 2013, however, most bond investors, especially those with a high proportion of their holdings in long-term or intermediate-term bonds, have seen a negative return. This was true even for investors with holdings in Treasury bonds and investment-grade bonds.

Investors in high-yield (so-called “junk”) bonds have shown a positive return this year. The reason is a high correlation between these bonds and the stock market, and this has been a very good year for the stock market.

The reason most bond investors have been hurt this year is the rise in interest rates. When interest rates increase, the value of bonds falls. Longer-term bonds fall in value by higher percentages than intermediate-term and short-term bonds when rates increase. This is true even for Treasury bonds, backed by the U.S. government. This is known as interest-rate risk.

There is one category of bonds that retain their value when interest rates increase: floating-rate bonds. Interest rates on these bonds are adjusted periodically (generally 30, 60 or 90 days) to a pre-determined formula using rates such as LIBOR (London Interbank Offered Rate) or the Federal Funds rate.

Financial institutions protect themselves when they lend money by utilizing a variable interest rate rather than a fixed rate. When interest rates increase, the banks increase the rate that borrowers pay. Loans based on variable interest rates are packaged and offered to mutual funds that offer them to investors. Investors who purchase these floating-rate bond funds are not subject to interest-rate risk. (They are subject to other risks.) Therefore, in periods when interest rates are expected to increase, floating-rate funds become more popular.

In 2013, investors in these bonds generally had a positive return on their investment. For example, the Fidelity Floating Rate High Income Fund (FFRHX), which receives a four-star rating from Morningstar, had a year-to-date return of 2.27 percent, as of September 2013. (This compares favorably to most bond funds, many of which had losses exceeding 2 percent.)

What are the risks associated with floating-rate bonds? One is credit risk, the possibility that the payer of interest will default. Regarding floating-rate bond funds, the interest is being paid by bank customers taking out loans. The magnitude of credit risk is much greater than it is with a Treasury fund or a high-quality corporate bond fund. The credit risk is equivalent to that associated with a junk bond fund.

Vanguard has issued an excellent “Primer on Floating-Rate Bond Funds,” written by Donald G. Bennyhoff and Yan Zilbering. It’s available online, and discusses advantages and disadvantages of this investment. The authors explain investors should also be aware of inflation risk. Even though floating-rate bond funds may provide a positive return, the returns may not keep pace with inflation. On a long-term basis, you may obtain higher returns with a balanced fund or target fund, both of which have a significant percentage of holdings in common stocks, which should provide better inflation protection.

Another issue for those interested in floating-rate bond funds is timing. Although these funds provide positive returns during periods of increase, rates are not that easy to predict. As we have seen this year, it is not easy to predict the policies of the Federal Reserve from one announcement to the next.

Investors concerned about capital preservation and need income can consider some investment in floating-rate bond funds. However, taking into consideration other risks associated with the product, I don’t believe this type of investment should be a significant part of your overall portfolio.

Email Elliot Raphaelson at elliotraph@gmail.com.


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