Don't Fear Rising Rates

Smart bond strategies can still pay off

On the face of it, the picture doesn't look that bright for bonds. The Federal Reserve is widely expected to begin hiking interest rates before yearend. Credit-rating downgrades continue to plague Corporate America. And there are fears the weakening dollar could prompt foreign investors to start dumping their sizable holdings of U.S. debt.

If bonds look scary, stocks probably look even more so. So like it or not, investors need to find a way to invest comfortably in bonds.

Take, for example, the prospect of Fed rate hikes. At such a time, investors are typically advised to stick with shorter maturities, so they're not locked into below-market returns. But since no one can predict when the Fed will reverse course, some bond pros recommend a "barbell" strategy, in which you split your holdings between short (up to six months) and long (10 to 15 years) maturities. If rates rise, you can reinvest the proceeds of short-term bonds when they mature. And just as 10- to 15-year bonds barely budged during the Fed's easing, some pros expect them to hold fairly steady if rates move up.

You also need to keep your portfolio well-diversified to protect against deteriorating credit quality. On that count, mortgage-backed securities issued by Fannie Mae (FNM ), Freddie Mac (FRE ), and Ginnie Mae are your best bet. These securities yield about 1.9 points more than comparable U.S. Treasury securities. Kevin Cronin, chief investment officer for fixed-income at Putnam Investments, says mortgage-backed securities will perform best if interest rates hold steady, which he expects to be the case over the next six months. But even when rates rise, he says, the extra yield on mortgage securities will help cushion any price declines.

What about Treasuries? Cronin says they've become pricey as investors have flocked to safety amid a sagging stock market and Middle East turmoil. The yield on 10-year government notes slipped to 4.8% on June 14, the lowest level this year. Cronin believes Treasury prices will head south again if Washington steps up bond sales to finance the mounting budget deficit. For Treasury debt, individual investors might fare better with either Series I savings bonds or Treasury Inflation-Indexed Securities (TIIS), both of which adjust the interest rate periodically to protect against inflation (table).

If you can tolerate more risk, corporate bonds beaten down to a lower investment grade, or even junk status, may be the way to go. These bonds recently yielded as much as 10.5%. But unless you have a multimillion-dollar portfolio that can hold a diversified mix of issues, stick with a bond fund. Two top-notch choices that have loaded up on the fallen debt of troubled telecom and energy companies are PIMCO Total Return, run by renowned bond manager William Gross, and Metropolitan West Total Return Bond Fund. "We're at the bottom of the credit cycle," says Stephen Kane, co-manager of Metropolitan West. As the economy picks up, the fortunes of these battered companies should improve.

Also consider adding a fund that invests in foreign bonds. Since such debt gains in value when the dollar falls, these funds could generate some capital gains as well as interest income. Foreign bond funds focus either on industrialized nations or emerging markets. Two excellent picks: T. Rowe Price International Bond Fund, up 7.02% this year through June 14, and PIMCO Emerging Markets Bond, up 2.84%.

Bonds would be easy to write off today. But you can find investments that should steady, if not pump up, your overall portfolio.

By Susan Scherreik

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