For the last four years, investors have braced for higher rates, only to be confounded by a fickle bond market. While most observers expect the Federal Reserve to raise short-term rates, probably in the second half of 2015, that's no sure thing. And even if it does, rates likely will only go up in small steps of 0.25 percentage point at a time.
What's a bond investor to do with another year of uncertainty ahead? Build a mix that straddles the fence between the odd chance that rates will stay lower longer than the world anticipates and the possibility that rates will rise, albeit slowly. Shortening maturities, the traditional strategy for coping with rising rates, may not be the best move this time around. And a strategy of investing in high-yield "junk" bonds, which usually hold up well when rates climb, may not work this year given the woes of the energy sector.
The six funds we discuss here will earn you a good yield and provide some defense against interest-rate uncertainty.
Fidelity Total Bond
Fund type: Intermediate-term bond
Yield: 2.7%
1-year total return: 4.8%
5-year annualized return: 5.3%
Expense ratio: 0.45%
In almost all markets, a diversified, medium-maturity fund should be at the core of your bond portfolio.
DoubleLine Total Return Bond
Fund type: Intermediate-term bond
Yield: 3.8%
1-year total return: 4.9%
5-year annualized return: N/A
Expense ratio: 0.73%
DoubleLine Total Return Bond (DLTNX), which specializes in mortgage-backed securities, isn't as diversified as
Fidelity Floating Rate High Income
Fund type: Bank loan
Yield: 4.4%
1-year total return: 1.0%
5-year annualized return: 4.2%
Expense ratio: 0.69%
Rising rates are bad news for holders of most kinds of bonds, but not for investors in floating-rate bank loans. That's because rates on these loans are tied to a short-term benchmark and reset every 30 to 90 days. The downside is that the borrowers are generally companies with below-investment-grade credit ratings. That's why we like funds that focus on loans on the higher end of the sub-investment-grade scale.
Our favorite bank-loan fund is
Because of the fund's conservative approach, it typically isn't near the top of the pack in any given year. Over the past three years, Floating Rate High Income returned 3.4% annualized, trailing the average bank-loan fund by 1 percentage point per year. But the Fidelity fund has been 6% less volatile than its peers during the period and has excelled during troubling times. For example, in the midst of the financial crisis in 2008, the average bank-loan fund lost 29.7%, while the Fidelity fund surrendered 16.5%. Mollenhauer wasn't in charge then (he came on board in 2013), but he says he employs the same strategy as his predecessor.
Metropolitan West Unconstrained Bond
Fund type: Nontraditional bond
Yield: 1.5%
1-year total return: 2.9%
5-year annualized return: N/A
Expense ratio: 0.99%
Funds that can reach into any pocket of the bond market (and even bet against it) offer another way of coping with uncertainty and elevated risk. The four managers of Metropolitan West Unconstrained Bond (MWCRX) can do just that.
Lately, the foursome--Steve Kane, Laird Landmann,
Pimco Income
Fund type: Multisector bond
Yield: 3.8%
1-year total return: 5.8%
5-year annualized return: 11.3%
Expense ratio: 0.77%
With the sudden departure of founder
The portfolio, which has an average duration of 3.1 years, is divided into two parts. One part holds higher-yielding securities--such as non-agency mortgage-backed securities, bank loans and corporate IOUs (both investment-grade and junk)--that the managers think will do well if the economy does better than expected. The other part holds high-quality assets, such as Treasuries and government-agency mortgage securities, to protect the portfolio if the economy does worse than expected. It's a good strategy for uncertain times.
Fidelity Intermediate Municipal Income
Fund type: Intermediate-term muni bond
Yield: 1.2%
1-year total return: 5.5%
5-year annualized return: 4.0%
Expense ratio: 0.37%
No matter what you invest in--stocks, real estate or even bonds--one way to play defense is to buy bargains. One area of the bond market that looks especially cheap today is municipal bonds. In early January, 10-year, triple-A-rated munis yielded an average of 1.9%. Because interest from munis is exempt from federal income tax (and sometimes from state and local income taxes, too), a 1.9% tax-free yield is equivalent to a taxable payout of 3.4% for someone in the highest federal tax bracket. That's not bad, considering that 10-year Treasuries yield just 2.1%.
And If Rates Rise?
Interest rates and bond prices move in opposite directions, so when rates rise, the value of a bond will fall. But that doesn't mean you always lose money. If you buy individual bonds and hold them to maturity, for example, interim rate moves won't matter. When the bond matures, you'll get your principal back--assuming, of course, that the issuer doesn't default.
Bond funds, however, are a different matter. Their managers buy and sell bonds continually and may or may not hold issues until they mature. So prices of bond funds change daily, and when you sell, you may get a lower price than you paid. To get a sense of how your bond fund will perform when rates rise, look at its average duration, a measure of interest-rate sensitivity. A fund with, say, an average duration of 3 years would likely suffer a 3% drop in net asset value if rates were to rise by one percentage point. But over time, the interest a fund pays you will offset some, if not all, of the decline in NAV. Consider, for example, DoubleLine Total Return (DBLTX), with a yield of 3.5% and an average duration of 3 years. If rates rise by one percentage point, the fund would likely deliver a small positive total return.
Where's the Junk Fund ?
Why don't we have a high-yield fund on our list of moves to make this year? After a sluggish 2014, the average yield of junk-rated corporate bonds has climbed to 6.2%, outstripping the yield of the average investment-grade corporate bond by 3.1 percentage points. Moreover, the growing strength of the U.S. economy redounds to the benefit of junk issuers, decreasing the chance that they'll default on their debt obligations.
The problem is the energy sector: Debt issued by energy companies makes up 13.4% of the
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Nellie S. Huang is Senior Associate Editor at Kiplinger's Personal Finance magazine.