By John Wasik
CHICAGO, June 25 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
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
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.
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
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.