Bonds: How to Play Interest Rate Peril

Interest rates can turn quickly, as the Greek government learned when its 10-year bond soared more than 9 percentage points in the past year on default worries. Such danger has some fixed-income investors considering a new approach: mutual funds that hold a variety of bonds, including U.S. Treasuries, corporates, mortgage-backed securities, municipals, and senior bank loans. Especially attractive now are multisector funds touting a more active approach to portfolio management, with the flexibility to drift from benchmark allocations to respond to changing market conditions.

Fund tracker Morningstar (MORN) estimates that 22 so-called unconstrained bond funds currently manage a total of $53 billion in assets. That's roughly a quarter of 87 multisector bond funds Morningstar has identified with assets under management totaling around $169 billion. The new breed of fund accounts for just a meager fraction of the $2 trillion held by 1,127 taxable bond funds. Fund flows for 12 of the 22 unconstrained funds have generally trended higher since January, with five funds showing big spikes in April or May as the debate around the U.S. debt ceiling heated up. The strategies of these "go-anywhere" funds aren't uniform. Some focus on reducing their portfolio's average duration (the percentage by which a bond's value is likely to drop for every 1 percent rise in interest rates), while others concentrate on getting the highest yield for the least amount of credit risk.

"Multisector funds have been most popular because people are thinking, 'Is there a bond bubble?'" says Philip Condon, head of municipal bonds at DWS Investments in New York. "Investors recognize that Treasuries probably aren't the best value when you see yields" below 3 percent. "Multisector bond funds are offering the ability to find that value in the marketplace."

The nimbleness of these actively managed funds comes at a price. In place of interest rate risk, they often expose investors to elevated credit risk or, in the case of certain emerging market debt, liquidity risk. And some of these funds charge fees roughly twice as high as funds focused on a specific part of the fixed-income market, although high-yield and short-duration funds also tend to have higher fees. "In general, it's a pretty untested group," says Miriam Sjoblom, a bond fund analyst at Morningstar. "We don't have a long track record of seeing how these funds hold up in different environments."

Shorter Duration, Lower Risk

When interest rates rise, bond yields move higher, pushing prices of existing bonds lower and causing investors to lose principal on the bonds in their portfolios. The best protection from this, many believe, is to lower the duration of the bonds they hold, which limits the loss of principal and allows fund managers to buy higher-yielding bonds sooner once interest rates begin to climb. A bond's duration measures how sensitive its price is to a change in interest rates and is calculated by taking the final maturity and yield into consideration.

Rick Rieder, BlackRock's (BLK) chief investment officer for actively managed fixed income and manager of the firm's Strategic Income Opportunities Fund (BASIX), is less concerned now about being burned by rising interest rates than he was six months ago, when the U.S. economy seemed to be on a more certain growth track. In late 2010 and early 2011, Rieder says he had a larger exposure to "risk assets," such as high-yield corporate bonds.

"We still have exposures to high yield and commercial mortgages but have reduced those exposures significantly over the last two months, mostly in anticipation of the end of quantitative easing 2 and increased volatility around that," he says. "The summer is a tougher liquidity period generally, and QE2 provided a tremendous foundation of liquidity because of what the Fed was putting into the system."

When Will Rates Go Up?

The probability of slower economic growth, at least until later this year, has lowered duration risk, in Rieder's view. Horizon Advisors, an advisory firm in Houston, has upped its allocation to bonds with durations of two to three years or less to 50 percent from the typical 20 percent, says Owen Murray, director of investments. The firm has a more optimistic take on the U.S. economy than most advisers, he says. In February, Horizon sold its 20 percent allocation to Treasury Inflation-Protected Securities (TIPS) in a BlackRock fund in favor of low-duration bonds. The typically longer maturities and low coupons of TIPS make them more sensitive to interest rate hikes.

Murray expects interest rates to rise sooner, due to bond investors' insistence on being paid more for the money they're lending than because of policy changes by the Federal Reserve. The wake-up call for bond investors, he says, could come in March 2012 if they see equity fund managers report returns of as much as 30 percent a year since the March 2009 lows. That would make them see how much money they have given up by sticking with low-yielding bond portfolios, he adds. He has also trimmed positions in Pimco's Total Return Fund and the Loomis Sayles Bond Institutional Fund (LSBDX), with durations of 3.7 and 5.7 years, respectively, using the proceeds to add to positions in the Janus Short-Term Bond Fund (JSHIX) and the Fidelity Short-Intermediate Muni Income Fund (FSTFX), with durations of 1.9 and 2.6 years, respectively.

The Eaton Vance Strategic Income Fund (ESIIX) generally aims for low durations, since its priority is on low volatility. But its current duration of 1.17 years is one of its lowest ever, vs. a 10-year average duration of 1 to 4 years. "We don't think you're getting compensated to take a lot of duration risk in the market," says fund co-manager Eric Stein. The best place to find extra yield now is from emerging market debt, with yields between 6 percent and 8 percent, and the opportunity for local currency appreciation, Stein says.

Switching from Fund to Fund

Some financial advisers want to make sure the funds they're investing in are able to reduce durations significantly and exit some sectors rather than just underweight them. Daniel Roe, a principal at Budros Ruhlin & Roe, a financial advisory firm in Columbus, Ohio, reduced his "significant position" in the Loomis Sayles Bond Institutional Fund out of concern that the portfolio manager couldn't get sufficiently defensive to meet Roe's objectives for his clients. "If we want our overall fixed-income strategy to have a shorter duration, we need to take some money and go somewhere else," Roe says. He has trimmed his Loomis position 29 percent since early May and invested in the BlackRock Strategic Income Fund for its flexibility to move to shorter durations and eliminate some sector positions entirely.

For its part, Loomis Sayles isn't worried about higher interest rates soon. "We're looking at a continuation of the steep yield curve in the U.S., where you're getting paid to be out the curve," says Brian Kennedy, product manager for multisector funds at Loomis Sayles. Still, he believes Loomis Sayles' bond funds are less sensitive to interest rate hikes than the funds' modified durations of around six years suggest. That's because the portfolio managers choose bonds that are less correlated to changes in interest rates and general market conditions and more likely to trade on the merits of their own credit profiles, he says.

When trying to minimize a portfolio's exposure to rising interest rates, investors aren't necessarily better off paring positions in longer-dated bonds in favor of intermediate maturities, says Condon at DWS. "That misses the point. When the yield curve is as steep as it is, if you were to sell longer-term maturities and move into 5- to 7-year maturities, you'll find intermediate maturities may be hurt more" when rates rise."

Instead, some bond managers recommend a barbell strategy, in which an investor maintains longer durations but hedges them with a position in an ultrashort-duration bond fund. For do-it-yourself investors with taxable accounts, Marilyn Cohen, editor of the Bond Smart Investor newsletter, suggests swapping shorter-duration bonds for cheaper longer-duration bonds issued by the same company or government to take advantage of premiums before they erode. Premiums on bonds with only a couple of years left until maturity decline fast, because the bond can pay off only at par value, while a longer-term bond has more time value locked into its duration, she explains.

But since it's hard for many investors to keep abreast of the nuances in every sector, Cohen offers a tip: Choose a "star fund manager who really utilizes his flexibility preemptively, as opposed to when the house is burning down."

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