By John Wasik
CHICAGO, March 31 (Reuters) - As the financial markets await more signals on the Federal Reserve's interest-rate policy next year, which may push rates higher in early 2015, it wouldn't hurt to take a close look at alternative bond funds.
Unlike conventional bond index funds, which may hold static portfolios, "unconstrained" or "hedged" funds are able to be nimble when rates rise. Although they may not totally avoid losses that could come with rising rates, they could avoid some of the volatility. Ten bond dealers out of 17 polled by Reuters see the Fed raising rates in the second half of 2015, with another four saying increases would not start until 2016.
Last Friday, Charles Evans, president of the Federal Reserve Bank of Chicago, said eventual rate hikes would likely follow a "shallower path of increases."
One way of avoiding losses in your income portfolio is to shorten maturities of the single bonds you're buying or shorten durations in the bond funds you own. Duration is a measure of interest-rate risk. If your fund has a duration of 3, you could lose 3 percent if rates climb one percentage point.
Another worthy consideration are bond funds that hedge interest-rate risk or have the ability to shift their portfolios into less-volatile bonds.
For example, the ProShares High Yield-Interest Rate Hedged ETF tracks an index investing in high-yield corporate bonds, but holds short positions in U.S. Treasury securities. The strategy is that a rise in rates - hurting the junk bonds - will be offset by the short Treasuries.
The ProShares fund, charging 0.5 percent for annual expenses, is up nearly 1 percent year to date through March 28, compared with nearly 2 percent for the Barclays U.S. Aggregate bond total return index, a proxy for the U.S. bond market.
What's unique about the ProShares fund is that it targets a zero duration, which means it's designed not to lose value if rates rise.
Another approach is an "unconstrained" fund that has flexibility to buy a variety of bonds, depending upon market conditions. The AllianceBernstein Unconstrained Bond Fund I (AGLIX), with an expense ratio of 0.6 percent annually, concentrates on preservation of capital.
Last year, when the overall bond market, as measured by the Barclays index, dipped 2 percent, the AllianceBernstein fund rose 0.48 percent. It's up 1.2 percent year to date through March 28.
Although the unconstrained or hedged approach makes sense for some investors, not every fund with that strategy will do well, since it often involves an active manager gauging where the market is headed.
The Pimco Unconstrained Bond D (PUBDX), not only underperformed its benchmark in recent years, but it's also expensive for a bond fund, charging 1.3 percent in annual expenses. An all-purpose exchange-traded fund like the iShares Core Total US Bond Market ETF, in comparison, charges 0.16 percent annually.
The Pimco fund lost 2.6 percent last year and trails the Barclays average in annualized returns over the past three years by nearly 2 percentage points, which is a large gap for income funds. (Disclosure: I hold the iShares fund in my 401(k).)
You may be better off in a short- or ultra-short-term bond fund, which keeps maturities and durations low, which means they're not that volatile.
The iShares Core Short-Term US Bond fund, has a duration of around 2. It made money last year, gaining 0.62 percent and is up 0.23 percent year to date through March 28. It costs 0.12 percent in annual expenses. A similar fund is the SPDR Barclays Capital Short-Term Bond Fund. It rose 1.3 percent last year and is up 0.4 percent year to date through March 28. It also costs 0.12 percent to own.
Keep in mind that with any bond fund that provides some insulation to interest-rate risk, there's a trade-off. With shorter-maturity bond funds, you'll see a lower yield than the broader bond market. Hedged funds are more expensive to own, which eats into your yield.
How you use these funds depends upon how you manage your income portfolio. Short-term and hedged products may be best for cash management: Money that you will need for paying taxes, coming homeowner expenses and other expenditures you expect within the next year.
A more diversified approach - particularly for those who are in or near retirement - is needed long-term. You'll need a mix of floating-rate or senior loan exchange-traded funds, municipal/government/emerging market and corporate bonds of varying maturities. If you own single bonds, hold them to maturity or buy bonds with higher yields as they come on the market.
If you construct an income portfolio with broad holdings that is diversified, it will allow you to pay less attention to what's happening with the Federal Reserve. Having a customized plan in place will help prepare you for inevitable interest rate hikes - even if they are telegraphed well in advance. (Follow us @ReutersMoney or here; Editing by Beth Pinsker and Dan Grebler)