Riding up the yield curve in bonds

CHICAGO Fri Mar 9, 2012 4:51pm EST

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CHICAGO (Reuters) - Should you be "riding up" the bond yield curve to boost returns in your income portfolio?

While some investors may think that bonds are tame beasts, higher yields always translate into higher risks. There may be some interesting opportunities available to boost income, but you need to be careful. Longer-maturity corporate and Treasury bonds can still give you a rodeo-horse kick.

With the Federal Reserve expected to leave interest rates in the basement for the next two years or so, it's only natural that you look outside of short-term Treasuries and insured deposits. Many investors have already moved from U.S. short-maturity bonds to longer-maturity issues in corporate, high-yield or corporate "junk bond" funds, according to data from Lipper, a Thomson Reuters company.

The amount of money flowing into high-yield funds alone in January and February -- some $10 billion -- led all income funds, according to Lipper. Investors pulled money out of short-term U.S. government and international income funds, which showed negative fund flows for February.

If you can afford the additional risk, going for some additional yield makes sense -- as long as you're diversified. While no principal is guaranteed in any bond mutual or exchange-traded fund, you may be able to boost your yield several percentage points.

When you move up the yield curve, take a close look at duration, a measure of the percentage decline expected in that fund if rates rise 1 percentage point. This is an essential risk gauge for any income investor. Generally, the longer the duration, the more money you can lose if rates rise.

Lawrence Weinman, a registered investment adviser in Los Angeles, points out that even a modest steepening of the yield curve in your portfolio can ratchet up risk dramatically.

For example, let's say you moved your money from the Vanguard Intermediate Term Corporate Bond ETF (VCIT) to the company's Long-Term Corporate ETF (VCLT). While you pick up 1.38 percentage points in additional yield, duration increases from 6 to 13 -- a more than doubling of risk. Weinman warns that the higher yield on the longer-term fund may not translate into a better risk-adjusted return.

"I'm really cautious on long-term corporates," Weinman says. Weinman suggests that a better, perhaps safer, core income holding is the Vanguard GNMA fund (VFIIX). The fund holds mortgage securities guaranteed by the full faith and credit of the U.S. Treasury and is yielding just over 3 percent. It's considered an intermediate-term fund.

If the economy keeps recovering -- the recent U.S. jobs report lends credence to this idea -- credit risk for corporate bonds generally declines. Still, you need to be concerned about inflation, the prime enemy of bond funds in general.

Although they haven't been a factor in the past three years, if energy prices remain high -- or rise even more -- and the economy reignites, this is another reason to keep your bond maturities low. Lately though, the Fed hasn't been all that concerned about inflation. Housing prices keep falling in most cities, and there seems to be a modest rebound afoot tempered by European and Middle East anxieties. Wages haven't followed an inflationary pattern.

That doesn't mean you should forsake inflation protection. Typically that means inflation-indexed bonds. One way of sampling short-term U.S. Treasury Inflation-Protected bonds (or TIPs), is through the PIMCO 1-5 Year US TIPs fund (STPZ), Weinman suggests. The PIMCO fund is not an income play, as it's reporting a negative yield. As with all TIPs at the moment, think of them as insulation from future shocks.

Want to play it ultra-safe? Buy short- and medium-maturity single Treasury bonds and hold them to maturity. You can buy conventional and inflation-adjusted bonds directly from the Treasury at treasury-direct.gov. If we return to a rising rate environment, as they mature, you can replace them with higher-yielding bonds without any loss of principal.

Another mistake to avoid is looking at what long-maturity bond funds returned last year and chasing those returns this year.

Remember that last year the U.S. and Euro debt crises triggered a flood into U.S.-backed bonds. With both of those situations stabilizing this year, you may not see a repeat of 2011. That's the theory, anyway. Any major economic malady from Athens to Beijing could still blow that notion out of the water.

(The writer is a Reuters columnist. The opinions expressed are his own.)

(Editing by Andrea Evans)

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