5 Best Bond Funds to Buy for Rising Interest Rates

Don't let higher interest rates clobber your fixed-income holdings

Barring a big change in expectations, interest rates are finally going to rise off historically low levels in 2015, and that’s bad news for bond prices. Like the law of gravity, there’s no way around it: When interest rates rise, bond prices fall, which is why so many bondholders are starting to get nervous.

bond funds, interest ratesThe Federal Reserve is unwinding its program of bond buying, which has been tamping down longer-term rates. The Fed has also made clear that the market can expect a hike in short-term rates sometime next year. Like it or not, interest rates are going up across the yield curve.

When rates rise, new bonds offer better yields than older bonds, so the price on those old bonds needs to come down in order to find a buyer. That doesn’t matter if you own individual bonds and you hold them to maturity, but most people don’t. They own bonds through mutual funds, which not only lose value in a rising rate environment, but can get hit with redemptions, which causes a fund manager to sell into a weak market.

It can get ugly.

Happily, rising rates don’t have to clobber your fixed-income fund holdings if you’re properly positioned. Longer-term debt is much more sensitive to changes in interest rates than shorter-dated maturities, for one thing. Some debt classes also bounce around more than others. There are ways to protect yourself.

If you’re worried about rising rates hurting your bond holdings, you need to take some defensive steps. These five mutual funds offer portfolio protection when interest rates are headed up:

Vanguard Short-Term Investment Grade (VFSTX)

VanguardYield: 1.9%
Expense Ratio: 0.2%
No Load

Okay, the yield is nothing to get excited about, but we’re looking for funds that won’t get creamed on price when rates are headed up. This is more about defense than income, which is why Vanguard Short-Term Investment Grade (VFSTX) makes the grade.

Short-term holdings are your best friend when rates rise, and as the name says, this fund is all about short-term holdings. Indeed, the average duration is just 2.3 years, according to Morningstar. Nearly 60% of the portfolio consists of high-quality corporate debt.

VFSTX is up less than 2% for the year-to-date, underperforming its benchmark by about 2 percentage points. However, VFSTX has outperformed its benchmark in three of the last five years. Expenses run 0.2%, or $20 per $10,000 invested, and the minimum investment is only $3,000.

Dodge & Cox Income (DODIX)

Dodge & Cox Mutual funds 401(k)Yield: 3.1%
Expense Ratio: 0.43%
No Load

Dodge & Cox Income (DODIX) delivers a decent yield without binging on interest-rate or credit-risk. The portfolio’s average duration is 4.3 years, comprised mostly of investment-grade corporate bonds, government-guaranteed mortgages like Ginnie Mae securities, and short-term Treasuries. Short-term Treasuries hold up reasonably well when rates are rising, and government-guaranteed mortgages are less volatile than Treasuries.

The approach has proved its worth as interest rates have slowly crept up over the last year. Indeed, DODIX is up more than 7% over the last year, beating its benchmark by 1.7 percentage points.

The rest of its record is pretty good too. DODIX is up 5% to beat its benchmark by o.7% so far in 2014. It has also beaten its benchmark in four of the last five years. The minimum investment is $2,500.

Fidelity Floating Rate High Income (FFRHX)

Fidelity mutual fundsYield: 3.3%
Expense Ratio: 0.7%
No Load

Fidelity Floating Rate High Income (FFRHX) is a good choice for protection from rising rates on a couple of fronts. For one thing, it’s also concentrated heavily on shorter-date maturities. The average duration of FFRHX’s holdings is three to seven years. Even better, they have a built-in mechanism to adapt to changes in rates.

Floating rate notes have a feature where the coupon resets every 90 days according to what interest rates are doing. That’s terrific protection, but it does come at a price, as you’re trading interest rate risk for credit risk. If we slip into recession, some of this debt could default.

Of course, if we’re headed for recession, the Fed will slash rates, so you won’t need this kind of protection anyway. FFRHX is up 2% in 2014, underperforming its benchmark by 2 percentage points. It has outperformed its benchmark in four of the last five years. The minimum investment is $2,500.

Loomis Sayles Bond Fund (LSBRX)

Loomis Sayles 185Yield: 4%
Expense Ratio: 0.92%
No Load

With Loomis Sayles Bond Fund (LSBRX), we finally get into the realm of short-duration funds offering yields of more than 4%. LSBRX achieves that feat by owning a wide range of debt, including short-term Treasuriess, high-grade and junk corporate bonds, convertibles and foreign bonds. The average duration is 4.4 years.

If that doesn’t put your mind at ease, you’ll be glad to know that the fund’s manager is increasingly cautious about the state of the bond market and boosting liquidity every chance he gets.

LSBRX is up 7.2% so far in 2014, beating its benchmark by 2.6 percentage points. It has also beaten its benchmark in four of the last five years.

Osterweis Strategic Income (OSTIX)

Osterweis185Yield: 4.3%
Expense Ratio: 0.85%
No Load

Osterweis Strategic Income (OSTIX) is similar to FFRHX, but it has a shorter duration and tends take a different approach. Whereas Fidelity’s fund holds senior bank loans of various investment grades, OSTIX buys junk bonds with an average duration of less than two years, as well as convertible bonds.

The upside to that strategy is that it generates higher yield — in this case, a more-than-decent 4.3% — and both those assets classes do well when the market and economy are growing. Furthermore, the fund managers aren’t slow to make changes in anticipation of higher rates, like moving a big chunk into cash.

OSTIX is up 3.5% for the year-to-date, underperforming its benchmark by a percentage point. However, it has beaten its benchmark in four of the last five years. The minimum investment is $5,000.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2014/09/bond-funds-interest-rates/.

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