Subscriber Q&A: Waiting for Interest Rates to Rise

May 22, 2014

bondwheelSubscriber Question:

Given that interest rates are likely to rise, shouldn’t NoLoad FundX’s bond portfolio have more exposure to short-term bonds, floating-rate funds or Treasuries?

NoLoad FundX Answer:

We recognize that with rates at historic lows, they have to rise eventually, but we don’t think anyone can accurately predict when rates will rise or how rising rates will affect bonds. Remember that interest rates rise for different reasons (inflation, defaults) and in different ways (gradually, sharply)­, and higher rates don’t affect all bonds in the same way. High-yield bonds, for example, may be able to cushion a gradual increase in rates, but they’d be hurt if rates rose sharply or defaults increased.

We invest our fixed income portfolios based on what we can observe today and reassess our observations every month. This way, we’re able to take advantage of what’s doing well now, and we’re also led to change our portfolios as market conditions change.

We don’t think investors have to accept the low returns of short-term bonds at this point. Those who moved their bond portfolios into very short-term bonds four years ago because they feared rising rates have missed out on some good gains in the last few years.

Investors who turned to floating-rate funds in 2013 as rates inched up have been only modestly rewarded. While floating-rate funds can do well when rates rise (they were a good option when rates rose modestly before the 2008 credit crisis, for example), they may not be a great option in the next rate increase. These funds typically invest in low-quality bonds or bank loans made to companies whose credit quality is rated below-investment-grade. Currently they’re not providing investors with much reward in exchange for this credit risk. A better bet has been high-yield bonds, which also invest in low quality bonds, but because they are not adjustable, they have higher coupons, or payout rates.

Treasury bonds are seen by many as the ultimate low-risk investment, but they have risks of their own. With such low coupons, they are very susceptible to interest rates, and the longer the maturity, the more volatile they are. In March 2014, for example, when the yield on the 10-year Treasury rose a mere seven basis points (from 2.66% to 2.73%), iShares Barclays 7-10 Year Treasury ETF lost 0.77% of its value.

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