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If the Federal Reserve raises interest rates later this year to keep the economy from overheating, hip, hip hooray, right? That means the Great Recession really is in our rearview mirror. But harrumph might be the more appropriate response from many current or soon-to-be retirees, who could see the prices of their fixed-income holdings slump as a result.
Investors put more than $356 billion into fixed-income mutual funds last year, over 10 times as much as in 2008. But higher interest rates go with lower bond prices. And for most investors, who tend to own bond funds rather than hold individual bonds to maturity, lower prices can foreshadow losses. "If the Federal Reserve raises rates," New York University economics professor Ann Lee explains, "that signals a recovery is under way"—bullish for stocks, bearish for bonds. It's scary for older Americans who, to reduce risk, typically invest heavily in fixed-income assets.
Following the 2001-02 downturn, the Barclays U.S. Aggregate Bond Index, a proxy for the U.S. bond market, lost more than 2% in 2004's second quarter in anticipation of rate hikes. (The Fed went on to boost rates by more than four points, to 5.25%, over 24 months.) This time around, economists don't expect the Fed to increase the federal funds rate from its current 0% to 0.25% range until November 2010, according to a Bloomberg survey. And even then, most are betting on only a quarter-point bump.
So there's no need for investors—especially those at or near retirement—to rush to sell bond holdings. The smart move is to build a diversified bond portfolio that will offset the impact of rising rates. Here are the strategies experts say are most effective.
The yields of short-term bonds, which have average maturities of less than three years, have hovered below 1.5% for more than a year. In search of a bigger payout, mutual-fund investors have poured a lot of money into higher-yielding, longer-term bonds. In early 2009, more than $269 billion sat in intermediate and long-term bond funds, according to researcher EPFR. Today $436 billion, nearly 72% of all bond fund assets, are in these longer-term funds. That could become a big problem when rates begin to rise, because the longer a bond's maturity, the more sensitive its price is to rate changes, says Morningstar (MORN) director of personal finance Christine Benz.
Benz suggests investors avoid holding only the super-safe stuff, like Treasury bonds with maturities greater than 10 years, municipal bonds, government-backed agency bonds, and high-grade corporate debt. Opt for go-anywhere intermediate-term bond funds including Harbor Bond (HABDX) and Dodge & Cox Income (DODIX), whose experienced managers know how to navigate this kind of market. Savings investors need to tap within the next five years should be in cash, money market funds, very short-term Treasury securities, or a fund like T. Rowe Price Short-Term Bond that owns short-term corporate debt, she adds.
Most longer-term government bonds yield less than 4% now. That's not much, especially considering the significant risk that rates will rise. Bigger payouts can be found in corporate and foreign bonds, which have yields of 5% or more to pay investors for taking on credit risk. When interest rates increase, these bonds can often offset price drops with their higher yields, and "a strong global economy would improve the credit quality," says Tom Latta, investment management and guidance executive at Merrill Lynch Global Wealth Management. Floating-rate bonds and bank loans issued by low-quality companies also offer higher yields with little interest-rate risk because the payouts adjust along with rates. Latta suggests most investors limit exposure to risky corporate and foreign debt to no more than 15% of their bond holdings.
As with other types of bonds, the higher-risk variety is best bought through mutual funds. Morningstar recommends the Vanguard High-Yield Corporate Fund (VWEHX) and Fidelity Floating Rate High Income (FFRHX). In 2004, when rates were hiked, they returned 9% and 5%, respectively. Fidelity New Markets Income Fund (FNMIX), meanwhile, ranks among the best in emerging-markets bond funds, with four out of five stars. Morningstar analyst William Samuel Rocco recommends this fund for investors willing to stick with it over the long haul. Over the past decade it has returned an average of 12% a year. A plus for older investors: The fund's volatility has been moderate, especially for an emerging-markets bond offering.
Multisector bond funds are another way to go. They typically buy both high-yield corporate and emerging-market debt and can invest anywhere. Morningstar favorites include Fidelity Strategic Income (FSICX) and Loomis Sayles Bond (LSBRX).
Inflation worries commonly trigger a rate hike. While it's anybody's guess how bad—or mild—price increases may be, "even the smallest amount of inflation is insidious," says Fidelity bond manager Joanna Bewick. Over the past 10 years the consumer price index increased by a modest 2.5% a year—but that adds up to almost 29%. Put another way, a cocktail that cost you $10 in 2000 will cost you an extra $2.90 today. "If you're sitting in cash and aren't taking on market risk, the risk in the erosion of buying power is pretty serious," says Bewick.
To protect against inflation, investors can add Treasury inflation-protected securities (TIPS), whose rates adjust with the rise of inflation and fall of deflation. Benz suggests having up to 30% of a bond allocation in TIPS. But TIPS prices tend to surge when inflation worries abound, says Benz, and "if you buy at the wrong time, it's possible to erode any inflation hedge." TIPS rose 10% last year, so they're pricey. To reduce the risk of buying at a bad time, consider a diversified fund like Vanguard Inflation-Protected Securities (VIPSX).
Older investors should focus on a portfolio's total return, not just income. Solid dividend-paying stocks bring the potential for capital appreciation as well as income. Morningstar sifted through top dividend-focused funds, including Oakmark Equity & Income (OAKBX), to identify overlapping holdings. A few prospects: Exelon (EXC), Diageo (DEO), and ConocoPhillips (COP). They have dividend yields of about 4.6%, 4.3%, and 4.2%, respectively.