I currently hold bond mutual funds. If interest rates rise, many of these funds will probably decline in value. This decline in value would offset, if not wipe out, the value I derive from the regular income these funds pay out.
Under the assumption that interest rates might rise from today's relatively low levels, what type of fixed-income mutual funds might I consider?
- R.B., Allentown, Pa.
Only a handful of fixed-income mutual funds perform relatively well when interest rates rise.
Two intertwined facts of life explain why this is so.
Bond prices tend to rise when interest rates fall.
Interest rates, with few interruptions, have generally drifted downward since September 1981. In this climate, taxable bond funds tracked by Lipper Inc. have, on average, suffered only two declining years (1994 and 1999) over the past quarter century. Fixed-income investors have had little reason to look for, or care about, funds that might perform well in a rising rate environment.
The interest rate tide, as you noted, might turn in the years ahead. Despite a slow rise from depths touched in June 2003, interest rates today remain low by historical measures. But if rates rise from where they are now, you might want to examine a few fixed-income investments that could perform better than some others.
Money market funds
There are no eye-catching prizes here at the moment: average annual yields of 1.45 percent as of mid-October. With such low yields, investors in money market funds are trailing the rate of inflation (2.9 percent, as measured by the Consumer Price Index) by 1.45 percentage points. But if short-term interest rates rise, money fund yields probably would rise as well. Money fund share prices, in this rising rate climate, would remain fixed at $1, which translates to no threat of loss on your principal.
If you think inflation will rise along with interest rates, consider TIPS. About 65 mutual funds buy and sell TIPS, an acronym for Treasury inflation-protected securities, also known as inflation-indexed securities. These inflation-linked bonds promise to pay higher rates of interest (tacked onto principal) as inflation rises.
"TIPS are a terrific hedge against rising inflation," said Andrew Clark, a fixed-income fund analyst with Lipper Inc. But, "if interest rates rise, and inflation does not, TIPS funds could under-perform other fixed-income investments," Clark said.
These funds, as the name suggests, buy packages of bank loans with variable rates.
As market interest rates rise, the rates charged to the borrowers rise as well. Investors, as a result, earn higher-than-money-market yields with a slightly higher threat of loss on principal. Such loans typically are made to borrowers with relatively low grades, or no ratings at all, from bond-rating agencies.
"This is one of the most attractive assets in a rising rate environment," said Eric Jacobson, a fund analyst with Morningstar Inc. And "because these are bank loans, they are a very secure part of the capital structure," said Paula Ryan, a managing director with Hartford Investment Management Co.
But floating-rate debt funds often carry high operating expenses: 1.48 percent a year, on average, according to Lipper.
Many floating-rate funds are also of the closed-end variety. These are mutual funds that trade like stocks; they consequently can trade at a premium to net asset value, which means would-be shareholders risk paying a price that's in excess of what the fund is really worth, Jacobson said.
These funds make reverse bets against longer-term U.S. government agency bonds. If government bond prices fall, these funds rise in value; if those same bond prices rise, these funds suffer a loss in net asset value.
Today, two such funds, Rydex Juno Investor (ticker symbol RYJUX) and ProFunds Rising Rates Opportunity Fund (RRPIX), make bets on rising rates and falling bond prices.
"If you don't need to take income, and if you're right about rates eventually rising, you can hold these funds for more than a year and declare a long-term capital gain after you sell them," said Donald Cassidy, an analyst for Lipper.
But rising-rates funds are not for the faint of heart. They typically do not pay interest or monthly dividends. And who can be sure that interest rates will rise from today's levels?
Matthew Lubanko is a columnist for The Hartford Courant, a Tribune Publishing newspaper. E-mail him at email@example.com.