3 Bond Funds for Rising Interest Rates

bond funds - 3 Bond Funds for Rising Interest Rates

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What many do not understand about bond funds is that they work in the opposite direction as interest rates. Even less understood is the multi-decade rally they enjoyed. Between 1981 and about 2016, bonds saw a bull run from the high inflation rates of the early 1980s to the ultra-low interest rates seen for most of this decade.

However, the bull market in bonds looks to have ended. Now with interest rates recovering from almost 0% levels (and negative rates in some foreign markets), signs of rising interest rates have appeared everywhere. This has negative effects on the value of bonds and could signal that a sustained bear market in bonds could be developing.

Investors also need to learn the difference between purchasing bonds and bond funds. When one purchases a bond, the borrower returns the principal when the bond matures. However, bond funds do not mature. Hence, investors who lose on bond funds face the possibility of never recovering their original investment and need to remain vigilant in a bear-market scenario.

Given the historically high value of bonds, investors need to prepare for such a scenario. These funds will help owners of bond funds preserve more wealth no matter what happens with rising rates.

Intermediate-Term Bonds – DoubleLine Total Return Bond Fund Class N (DLTNX)

Market predictions often turn out wrong. Despite more than three and one-half decades of a falling interest rate environment, nobody knows for sure what interest rates will do. One way to hedge that bet is by placing money into intermediate-term bond funds. These funds invest in bonds with maturity dates between five and 10 years.

The DoubleLine Total Return Bond Fund Class N (MUTF:DLTNX) shows a history of strong returns. This fund received a four-star rating from Morningstar. DLTNX is made up mostly of mortgage-backed securities (MBSs).

The fund launched in 2010, so the MBSs that contributed to the financial crisis of 2008 will not be found in DLTNX. Moreover, over 70% of the debt held is rated AAA, which greatly lowers the risk profile.

However, just over 9% of the fund consists of high-risk debt. Per the “intermediate term” description, the average effective maturity of its debt stands at 5.36 years. Although the fund invests 86.4% of its assets in securitized investments such as MBSs, the fund’s top two holdings consist of U.S. Treasury notes.

The fund gained 0.96% in the last year and an average of 2.1% over the last 10 years. While its fees may run high for such an investment, about 0.73%, the minimum investment required stands at $2,000.

Floating-Rate Bond Funds – Fidelity Floating Rate High Income Fund (FFRHX)

One remedy for potentially rising interest rates consists of floating-rate bond funds. As the name implies, this type of fund sees its value rise along with market interest rates. This differentiates this bond type from most other bonds, as bond values typically move in the opposite direction of interest rates.

However, investors should remain aware that these loans tend to carry heavier risks than a typical bond. Companies with poorer credit ratings tend to take on these loans. Hence, many of these funds saw steep losses in 2008.

The Fidelity Floating Rate High Income Fund (MUTF:FFRHX) has become one of the better performers in this niche. Active management has played a key role in the success of FFRHX. The fund only invests in loans to companies with a history of strong cash flows.

Because of this, Morningstar rates the fund’s risk as low despite the higher risk profile of the sector. The fund places about 85.2% of its assets in such loans, with about 5.3% going to corporate bonds. Most of the remainder of its funds stay in cash.

Investors can get in with a $2,500 minimum investment. They will also pay an expense of only 0.7%. FFRHX has also delivered more consistent returns over the short and long term.

Its one-year performance stood at 4%. Over 10 years, it averaged 4.14% per year, meaning it weathered the 2008 financial crisis well. The fund’s value fell temporarily by about 27% at the peak of the drop before recovering most of the loss by early 2010.

Its top holdings consist of loans to Caesars Entertainment Corporation (NYSE:CZR), Albertson’s LLC and Charter Communications Inc (NASDAQ:CHTR).

Treasury Inflation-Protected Securities (TIPS) – Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX)

Baby boomers will remember the days of double-digit inflation of the 1970s. If that group of investors fears higher interest rates, they will likely want the inflation protection offered by TIPS.

TIPS range in maturity from five to 20 years. While the rate does not change, the level of principal rises or falls with the consumer price index. This adjustment typically occurs every six months.

The Vanguard Inflation-Protected Securities Fund Investor Shares (MUTF:VIPSX) offers competitive returns in this category. It seeks to provide a “real return,” meaning one that compensates for the effects of inflation. With this fund, principal adjustments occur quarterly. The fund’s expenses stand at only 0.2%, and it does not list a minimum investment amount.

VIPSX has earned a return of 0.68% during the last 12 months, with the fund averaging a loss of 0.07% over the last five years. Its 10-year average stands at 2.73%. However, those last 10 years took place in an environment of mostly falling rates. Now that rates appear to have switched directions, this rate of return could change.

Morningstar rates both the risk and return of this fund as average. However, investors should take special notice of the fund’s active management.

Historically, the fund has placed an average of 87% into inflation-protected Treasuries during its history. Currently, the fund has placed 99.7% of its assets in TIPS. This “all-in” approach leaves little doubt as to what the managers think will happen with TIPS.

As of this writing, Will Healy did not hold a position in any of the aforementioned stocks or funds.


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