It has been close to five years since the financial crisis rocked the world’s economy. Since then, the Federal Reserve has taken extraordinary measures to pump up monetary policy, specifically through quantitative easing. The current round involves a hefty $85 billion in monthly purchases of bonds, which comes to about $1 trillion per year — a lot of money, even for the Fed.
However, the market has gotten the jitters amid hints that the Fed is planning on tapering off this easing. And it’s a reasonable possibility — the U.S. economy, while sluggish, is showing fundamental improvement. Unemployment is decreasing, real estate has rebounded and auto sales are up.
Also in anticipation of a Fed move, the 10-year Treasury bond has spiked from 1.7% to 2.2% since April.
This week, however, we might finally get more clarity on things following the Fed’s FOMC meeting, which concludes Wednesday.
While no one knows what Ben Bernanke will say for sure, investors should be prepared for the possibility of the Fed tightening down, and the potential for interest rates to continue to climb.
In such an environment, bonds tend to perform poorly, as reflected in many bond funds’ poor performance in the past month — the PIMCO Long Duration Total Return (PLRPX) and Vanguard Long-Term Investment-Grade (VWESX), for instance, have each shed nearly 4% as yields have inched upward.
The reason for this is the inverse relationship between the price of a bond and current interest rates. Prices on existing bonds need to fall — pushing up their yields — to compete with the higher rates on newly issued debt. The result is that those bonds take a loss.
To deal with this, one good idea is to seek out funds with a low duration, which is how long it takes for a portfolio to mature. This means a manager will get money back quicker, then can redeploy the capital into higher-yielding securities. (As a general rule of thumb, a low duration is under three years or so.)
In light of this, one option investors might consider right now is the Lord Abbett Short Duration Income (LALDX) fund, whose holdings have an average duration of only 1.9 years. LALDX is run by four portfolio managers and 28 analysts who search for high-quality corporate, mortgage and government bonds. According to the fund, the goal is to “provide a middle ground between money market and higher yielding portfolios with longer duration.” LALDX has a 3.76% trailing 12-month yield and a 30-day SEC yield of 2.17%. The fund’s A shares have a low expense ratio of 0.59%, though they also require a 2.25% sales charge.
Interestingly enough, some bonds have virtually no duration risk, such as floating-rate notes. These are investments that automatically adjust for interest-rate changes.
A top exchange-traded fund in the space is iShares Floating Rate Note ETF (FLOT). The fund primarily focuses on high-quality issues and boasts a high concentration of notes from financial institutions like JPMorgan Chase (JPM), Citigroup (C), Goldman Sachs (GS) and Wells Fargo (WFC). While FLOT is cheap at just 0.2% in expenses, note that it’s also not a high-yielder, either, with a current TTM yield of 0.84% and an SEC yield of 0.37%.
Of course, the thing to keep in mind with both LALDX and FLOT is that both probably aren’t going to produce eye-popping returns. If you’re willing to ramp up your risk, you could look at more aggressive approaches such as shorting bonds.
One way to do this is via the ProShares Short 20+ Year Treasury ETF (TBF), which seeks to return the inverse of the Barclays U.S. 20+ Year Treasury Bond Index. No doubt, because of the high duration, the returns can be juiced — but you also have to keep in mind that inverse and leveraged funds involve more risk, too. This isn’t for the faint of heart, but if you want to play, TBF chartes 0.95% in expenses.
Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.