Protect yourself against interest rate hikes

July 23, 2010

With money market and short-term U.S. government yields not very different from hiding your dollars under a mattress, huge amounts of investment dollars have gone into bond funds.

Key Points

On the other hand, the Federal Reserve has pledged to raise rates as the economy strengthens, and a rise in market rates results in losses in your fixed rate bonds. What should you do?

The simplest solution is to shift your bond holdings into shorter-term and intermediate-term bond funds, which, because they are repaid faster than longer-term bonds, will be less affected by a rise in rates. Of course, the yearly income earned on these bonds will be lower. Vanguard Short-Term Investment Grade (VFSTX) is a good choice here.

You could buy individual bonds and not bond funds. Doing so will give you the comfort of knowing you will get your money back when the bonds come due. Because bond funds buy and sell bonds all the time, they cannot provide that kind of certainty.

Even with that difference, individual bonds and bond funds tend to have similar overall performance. This similarity should not be surprising because mutual funds usually contain the same bonds you would purchase on your own.

If you buy individual corporate bonds, stick to those rated A or better that are traded on an exchange, where you can follow the recent activity.

Another option is to place a portion of your cash in lower-quality issues called high-yield bonds. These bonds can be influenced more by economic factors than by interest rates. When the economy strengthens, people gain confidence that the companies issuing them will be able to repay them at maturity, and the bonds often rise in price.

A good time to buy high-yield bonds is when business looks headed toward recovery and interest rates rise. Vanguard High-Yield Corporate (VWEHX) funds can fit the bill.

INTERNATIONAL FUNDS

You can place some money in international bond funds, particularly those concentrating in quality, developed markets. In northern European countries such as France, Germany, and Sweden, or, for inflation hedge purposes, Canada and Australia, commodity-based economics may be attractive targets.

Ironically, the more sluggish the country's economy, the more attractive their high-quality bonds are, because interest rates often fall when economic conditions are weak, strengthening existing holdings. T. Rowe Price International Bond (RPIBX) is a good choice here.

Consider allocating a portion of your bonds in each of the above areas. Limit yourself to a maximum of 10 percent in the high-yield area, and recognize that the general consensus is often wrong, as in "rates have nowhere to go but up."

However, unless the U.S. economy stalls or encounters deflation-an overall price decline-it stands to reason that short-term rates now being held down by the government, and most likely intermediate interest rates, will begin to rise, probably within the next year. Taking these steps should help protect you against the negative effects of that possibility.

The author is president of Altfest Personal Wealth Management, an investment advisory firm in New York City; an associate professor of finance at Pace University; and a Medical Economics consultant. The ideas expressed in this column are his alone and do not represent the views of Medical Economics. If you have a comment or a topic you would like to see covered here, please e-mail medec@advanstar.com
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