COLUMN-Bond moves to make as U.S. Fed fires warning shot on rates

Tue Jun 25, 2013 7:59am EDT

By John Wasik

CHICAGO, June 25 (Reuters) - Now that the U.S. Federal Reserve has announced it might wind down its stimulus program, and as rates rise, it's critical to adjust your portfolio.

Bond prices fell as yields rose to a near two-year high on Monday. The U.S. Treasury sell-off was sparked Fed Chairman Ben Bernanke's comments the central bank might begin scaling back purchases of Treasury and mortgage securities later this year.

The impact of rising interest rates, which depress bond prices, are measured directly through duration. Duration measures a bond portfolio's sensitivity to rates. For each one-percentage point uptick in rates, the duration gauge shows you how much money you can lose in principal. Generally, the longer the duration, the greater the chance you'll lose money.

Say you have an investment-grade bond with a duration of 14.5 years that carries a 4.5 percent coupon and matures in 30 years. If rates tick up two percentage points, you could lose 26 percent of the bond's market value. Every bond portfolio prospectus or website should give you duration measures. They can also be found on any financial portal online.

Of course, this is an extreme example, but you need to be careful to insure your portfolio is insulated from interest-rate risk, which is highest for long-maturity bonds.

"What really concerns us is an over-allocation to long dated bonds," notes Dan Keady, who is a certified financial planner and director of financial planning for New York-based TIAA-CREF, the financial services company. "How are you going to offset duration risk?"

Shortening bond maturities to single digits is one defensive approach. Buying funds that invest in bank loans is another.

TRACKING RISING RATES

Unlike conventional bond portfolios, bank-loan funds purchase floating-rate notes that can track rising rates. They've been extremely popular this year as rates inched up and investors have pulled money out of conventional income funds.

Relative to intermediate or long-maturity bond funds, bank-loan durations are miniscule, typically under one year, so they have some of the lowest rate-risk profiles. While yields are also small, that is the trade-off for using this kind of fund.

More than $24 billion has flowed into bank-loan funds this year through May, according to Morningstar Inc, leading the top bond categories with a 30 percent growth rate. That compares with an outflow of more than $10 billion for intermediate government bond funds.

It's not too late to make adjustments if you hold long-maturity bonds since the Fed is not expected to begin curtailing its easing program until later this year.

While there are more than 40 mutual funds that invest in floating-rate loans, I don't recommend them because of high expenses of around 1 percent annually, which is lofty for a bond fund. Bank loans are best held through exchange-traded fund portfolios, which have much lower costs.

Here are three worthy candidates:

SPDR Barclays Investment Grade Floating Rate ETF. With a 1.3 percent yield, the fund tracks the Barclays US Floating Rate 5-year Index. It has returned nearly 3 percent for the year through June 21 and owns notes from General Electric Co , Morgan Stanley and Wells Fargo & Co. Its duration is 0.11. On expenses, it's the cheapest among the ETFs at 0.15 percent annually.

iShares Floating Rate Note Fund. With a 0.95 percent yield, the fund also tracks the Barclays US Floating Rate Index. It's gained more than 2 percent for the year to date through June 21. The fund owns notes from Goldman Sachs Group Inc, Citigroup Inc and JP Morgan Chase & Co . Annual expenses are 0.20 percent annually. Its effective duration is 0.13 as some 95 percent of the notes in the portfolio have less than five-year maturities.

Market Vectors Investment Grade Floating Rate ETF. As the smallest fund by assets in this group, the Market Vectors fund offers a 1 percent yield and has returned nearly 6 percent over the past year. The major difference, other than its performance, is that it tracks its own index and costs slightly more than the other two funds at 0.19 percent annually. Its duration is incrementally lower at 0.07.

SOME CAVEATS

Keep in mind that, although current low yields on floating-rate funds may rise in time, you should not concentrate most of your income portfolio in them. You still need a diversified approach that includes short-term U.S. bonds, foreign and emerging markets, and high-yield corporate and municipal funds.

And while floating-rate portfolios have notes that reset when interest rates rise, if inflation returns to any degree, you should consider inflation-protected securities - Treasury bills that pay a bonus if the Consumer Price Index rises.

In terms of immediate cash management, forget yields and stick with ultra-short bond funds or money-market funds for amounts you will need within the next year or two. Do you have tax, college or emergency bills coming up? Then you need cash in vehicles that have virtually no duration or interest-rate risk.

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