Higher Rates: A Survival Kit

Plenty of options exist for maximizing yields in this climate

For nearly two years, investors have been talking about the day when interest rates would start to climb. Well, the bond market has started to push up long-term rates, and the betting is that the Federal Reserve will start raising short-term rates this summer. Rising rates are usually the bane of bondholders, but not if you own certain investments.

BANK-LOAN FUNDS

"Bank-loan" or "prime-rate" funds buy portions of loans made to corporate borrowers. The loan rates are generally pegged at 3.5 percentage points or more above the London interbank offered rate (LIBOR), now 1.17%. Because the rates on the loans change frequently -- typically every 90 days -- the funds' yields rise along with interest rates. Indeed, when rates spiked in 1994, the funds rose 6.6% on average, while long-term government bond funds lost 7.7%, according to fund researcher Morningstar.

Now may be a good time to buy such funds. Not only are their yields expected to rise, but their biggest risk -- that the loans they hold will default -- is less of a worry. "These loans are generally issued by companies that carry a junk-bond rating," says Eric Jacobson, senior analyst at Morningstar. But if "the economy is improving, you'd expect the credit quality of these companies to be improving, too."

Still, the average expense ratio is 1.47% of assets, or 35 basis points above that of the average bond fund. One alternative: Fidelity Floating Rate High Income Fund, which carries no sales charge and has a relatively modest 0.86% expense ratio. The Fidelity fund allows shareholders to pull money out at any time. Most other bank-loan funds restrict withdrawals to one day per month or quarter.

There's a price for that liquidity. In part because it needs to keep more cash on hand to meet redemptions, the Fidelity fund has earned an annual average of 3.63% over the past three years, vs. 4.56% for its peers, says Morningstar analyst Scott Berry. Still, with short rates expected to climb, returns are likely to rise.

INFLATION-PROOF BONDS

Inflation has been running about 2% a year for the past three years. But if you think it's likely to return to its long-term average of 3.9%, there's a good case for buying inflation-proof bonds. Issued by the Treasury and commonly known as "TIPS," these bonds will outperform regular Treasuries as long as inflation remains above 2.46% over the next decade. Why 2.46%? That's the difference between the 10-year Treasury's 4.42% yield on Apr. 26 and the TIPS' 1.95% -- and it's used to gauge what the market expects inflation to be over the bond's 10-year life. "If there's an inflation surprise, the inflation bond will do really well," says P. Brett Hammond, head of investment analytics at TIAA-CREF Investments. "People will see it as a port in the storm."

Here's how TIPS work: Twice a year the principal increases to offset any rise in inflation. That means that if you pay $1,000 for a TIPS bond and inflation is 3%, the principal will be boosted to about $1,030. Better still, the next interest payment will be computed on the new, $1,030 principal. You can place a minimum $1,000 order without commission via the TreasuryDirect program (www.publicdebt.treas.gov or 800 722-2678), or buy TIPS mutual funds from firms including Fidelity and Vanguard.

It's best to hold TIPS or TIPS funds in a tax-deferred account. That's because the Internal Revenue Service will tax you on the annual inflation adjustment even though you won't see a dime of it until the bond matures or you sell it. With I Bonds, inflation-adjusted U.S. savings bonds, you don't pay taxes on the inflation adjustments until you cash in the bond. However, the I Bond often has a lower interest rate.

SHORT-SELLING

If you have high tolerance for risk, think about selling bonds short. This strategy involves selling borrowed bonds in a margin account in the hope that their prices will fall. You can also short any of six exchange traded funds (ETFS), called iShares, that track various bond indexes. Since long-term bonds are the most volatile, the 7-to-10 year and 20-plus year Treasury bond ETFs offer the greatest opportunity for short-selling gains.

The risk, of course, is that if bonds rally, you'll have to replace your borrowed securities at a higher price. You also must reimburse the lender for any interest paid out while you hold the short position. You may be liable for other fees, too.

Two no-load mutual funds also offer a chance to profit from falling bond prices: Rydex Juno (RYJUX ) and ProFunds Rising Rates Opportunity. But unlike short-selling, you don't need a margin account, and you won't owe lenders any interest.

By Anne Tergesen

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