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How to beat rising rates

With bond prices falling, investors may have to look beyond traditional bonds. Here are four funds with yields up to 5%.

  • By Daren Fonda,
  • Fidelity Interactive Content Services
  • – 06/20/2013
  • Investing Strategies
  • Investing in Mutual Funds
  • Mutual Funds
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You can't fight the Fed, but can you thwart rising interest rates? With long-term rates rising in recent weeks — and bond prices falling — bond investors may be facing losses.

The yield on the benchmark 10-year Treasury note has surged to around 2.31% from 1.66% in early May, hitting its highest levels since March 2012. That has wiped out the bond market's total returns this year, resulting in a loss of 1.72%. (Bond prices and yields move in opposite directions).

Granted, there are some advantages to rising interest rates. The recent slump in bond prices may be a sign the economy is picking up, since investors typically sell bonds when they expect higher economic growth and inflation. If the economy does strengthen, corporate profits, and stock prices, would likely fare well. A stronger economy also would be positive for high-yield "junk" bonds, helping to keep default rates low.

For now, bond prices appear to be slumping on fears the Federal Reserve will pull back on its bond-buying program sooner than expected. The central bank is still buying around $85 billion worth of government debt every month, aiming to keep long-term interest rates down.

Unless the economy really takes off, though, some experts say the central bank is likely to maintain its bond-buying — or at least move gradually so as not to rattle financial markets. "Monetary policy is still working for us," says Joanna Bewick, a Fidelity Investments fixed-income manager. "I've never made money fighting the Fed."

Some professional investors, meanwhile, are actually buying bonds now that prices have dropped. David James, co-manager of the James Balanced: Golden Rainbow Fund (GLRBX), has increased his fund's bond exposure to 50% of assets from around 43%. "With yields around 2.2% it looks like a good time to buy," he says.

James notes that Fed reports on economic activity have turned negative in key regions like Chicago, New York, Virginia and Philadelphia. Historically, that has indicated a 60% chance of an economic contraction. Moreover, disposable income and consumer spending are growing around 2% annually — well below the 7% average of the past 50 years. "Things aren't quite as strong as people think," he says.

Yet even if bond prices stabilize around current levels, some bond pros expect returns going forward to come largely from the fixed interest rates most bonds pay, rather than price gains. "It's become more of a coupon-clipping world," says Bewick, referring to the "coupon" or fixed rate on most bonds.

So what's the best strategy in this challenging environment?

One approach is to make sure your bond funds aren't highly sensitive to interest rate moves. A fund's average duration can tell you if it's likely to stay in positive territory in a rising rate climate.

A fund with a duration of five years, for instance, indicates its share price would likely decline by 5 percentage points if market rates rise by a point. If the fund yields less than 5%, total returns would be negative. You can check a fund's average duration on sites like Morningstar.com and Fidelity.com.

Pull different income levers

Another approach is to pull other income levers, supplementing a core bond portfolio with dividend-paying stocks and other income sources such as high-yield debt, foreign bonds and convertible securities.

Several funds blend these investments in a bid to boost income and total returns. Adding some non-bond investments to a traditional bond portfolio may reduce its interest-rate sensitivity. And your long-term returns may be higher since there's more potential for capital gains.

Keep in mind if you buy one of these funds: Make sure your long-term portfolio mix stays intact. Funds that mix and match stocks, bonds and other assets may increase your exposure to risky assets and the volatility of your portfolio.

Also remember that everything is riskier than cash or money market funds — it's just a matter of degree. You should do your own research or talk to an adviser to determine the right asset mix and specific investments for you.

In the multi-sector bond space, one top performer is the PIMCO Income Fund (PONDX). The fund has trounced rivals over the last three years, beating 98% of peers, according to Morningstar.

Investing across the fixed-income spectrum, the fund holds everything from non-government mortgage bonds to emerging market debt. It yields around 3% and its sensitivity to interest rates is low with a duration averaging 3.7 years.

The downside: The fund is almost twice as volatile as the Barclays U.S. Aggregate Bond Index, according to Morningstar. It may hold up to half its assets in securities rated below investment-grade — investments that could tumble in a financial crisis.

Loomis Sayles Strategic Income (NEZYX) ventures beyond traditional bonds too. Around 22% of the fund is in high-yield debt, 10% is in convertibles and 19% is in preferred and common stocks, including dividend payers such as Bristol Myers Squibb (BMY) and Intel (INTC). The managers also invest in foreign markets, mainly Canada and Europe.

The fund beat 82% of rivals over the last five years, according to Morningstar. One of the fund's longtime managers, Kathleen Gaffney, left the fund company last year, notes Morningstar analyst Sarah Bush, but the fund is still run by a "capable and experienced team," including bond market veteran Dan Fuss.

The downside: The fund's stock exposure adds risk to the portfolio, which is more than three times as volatile as the Barclays U.S. Aggregate Bond Index, according to Morningstar. It costs $75 to buy shares on the Fidelity platform.

For investors who want more stock exposure, Fidelity Strategic Dividend & Income Fund (FSDIX) may be worth considering. Co-managed by Bewick, it holds around half its assets in large-cap stocks such as Chevron (CVX), Pfizer (PFE) and Procter & Gamble (PG). The rest is mainly preferred stocks, convertibles and REITs. Overall, it yields 2.3%, and it should have minimal sensitivity to rising interest rates since it doesn't hold traditional bonds.

With around 80% of its assets in stock securities, this fund doesn't fall in the bond category. Morningstar classifies it as a "large value" fund and it largely tracks the stock market — for better or worse. The fund beat 71% of rival stock funds over the last three years, according to Morningstar. But it's hit some rough patches, including a 41% plunge in 2008.

The downside: The fund's returns are largely driven by its stock holdings, which can be volatile.

Another fund for long-term investors to consider is AllianceBernstein High Income Fund (AGDYX). The fund focuses primarily on junk bonds, which account for roughly half its assets, and it holds around 26% in foreign bonds, including emerging market debt.

The fund yields 5.3% and has a duration averaging 4.4 years — indicating it would hold up well if rates rise modestly. Returns beat 96% of multi-sector bond funds over the last five years, according to Morningstar. Another plus: Most of its foreign-currency bonds are hedged against the dollar, limiting currency risk.

"In small doses, this fund can be a good source of income and diversification in a well-balanced fixed-income portfolio," Morningstar analyst Michelle Canavan recently wrote.

The downside: The managers roam widely across the bond universe and returns may be volatile. The fund plunged 26.2% in 2008 — far more than conservative bond funds — and then soared 62.2% in 2009. Since it generates significant income, it may be best held in a tax-deferred account. It costs $75 to buy shares on the Fidelity platform.


4 income funds

FUND NAME 3-YR. AVG. ANNUAL RTN 30-DAY SEC YIELD EXPENSE RATIO
PIMCO Income Fund (PONDX) 14.8% 3.1% 0.70%
Loomis Sayles Strategic Income (NEZYX) 11.6 3.4 0.71
Fidelity Strategic Dividend & Income Fund (FSDIX) 15.3 2.3 0.80
AllianceBernstein High Income Fund (AGDYX) 13.2 5.3 0.60

Source: Morningstar


Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.

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