In an Uncertain Rate Environment, What Should Bond Investors Do?

Late last year, with the U.S. economy picking up speed after an especially deep recession, many analysts warned that interest rates on bonds were headed higher. That was bad news for many small investors, who had fled the stock market's volatility for the safety of bonds. The latter's prices fall in value when rates go up, so a portfolio of long-term Treasury bonds would be worth less after an interest rate increase.

A lot of investors adopted a strategy of selling their long-term Treasurys and bought short-term debt, where interest rates tend to go up at a slower pace. But then came the Greek debt crisis, and all of a sudden, investors around the world were crowding into U.S. Treasurys. As a result, interest rates actually fell, reaching 3.059% on May 25, the lowest rate in 13 months.

"Some of the most sophisticated investors were absolutely convinced interest rates were going to rise," says Joanna Bewick, co-manager of Fidelity Investments' Strategic Dividend & Income Fund. "Had an investor followed conventional wisdom and sold off all their Treasurys in anticipation of higher rates, they would have been terribly burned because interest rates have fallen so dramatically."

Long-Term vs. Short-Term Bonds

Now that rates are once again so low -- they only began edging up last week as the European crisis subsided, at least temporarily -- what should investors do with the fixed-income portion of their portfolios? How can they hedge against the likelihood of increased inflation down the road now that the government is reporting the national debt will hit $19.6 trillion by 2015?

Roger Aliaga-Diaz, a senior economist with the Investment Strategy Group at mutual fund giant Vanguard, says despite the headwinds from Europe, interest rates in the U.S. are likely to start inching up when the Federal Reserve begins tightening by the end of this year or early 2011. But he says it would be a mistake to move away from long-term to short-term bonds in an effort to avoid capital losses from rising rates.

"What can happen in the U.S. and other countries where inflation is under control is that interest rates tend to increase more on the short end," he says. "This means there's no reason to believe you will lose more if you stay at the long end of the yield curve. You could lose more if you really push everything to the short end."

Focus on Income

Aliaga-Diaz says Vanguard is recommending that investors in fixed income remain well diversified across a range of different maturities because income is the important part of bond returns.

Even if yields increase and long-term bonds suffer some capital losses, they're producing higher income every month. When that income is reinvested, it more than offsets the losses from higher rates.

Vanguard has studied bouts of inflation in 1976 and 1981 and found that the income portion of the Treasury bond, plus reinvestment, more than compensated for capital losses. "Investors tend to focus too much on short-term capital losses and overreact by moving to shorter duration," Aliaga-Diazsays.

Other Relatively Safe Options

Fidelity's Bewick emphasizes other ways to invest in relatively safe bonds (compared to stocks) and mitigate the interest rate risk of Treasurys. They include corporate and high-yield bonds that pay a higher interest rate than Treasurys. The interest rate coupon on these bonds pays a fixed amount, say 2% to 3% over Treasurys, so the increased income will offset some of the capital losses investors experience when rates rise.

Another approach is to diversify interest rate regimes. While U.S. rates are headed higher, those in places like Germany have actually declined because of the European debt crisis. Rates on German bonds will probably stay low for some time, Bewick says, but the bonds themselves are very high quality. "Here's an opportunity where you can diversify among different interest rate environments and offset what might be rising interest rates in a healthier economy," she says.

A third strategy is to buy floating-rate debt. These are public market bank loans that are priced to float about 2% to 3% above Libor, the London interbank offering rate, which is the interest rate European banks charge to lend to each other. As interest rates rise, the returns on floating-rate debt also go up, which Bewick calls a "nice opportunity for diversification."

Impact of Inflation

Bewick says the worst thing investors can do is stay in cash while worrying about the market. "If investors are sitting on cash, although they may view themselves as preserving capital, mild inflation is a serious concern for their portfolios," she says.

Bewick recently conducted a study of inflation in the last 10 years and found that a dollar at the beginning of the decade is worth only 78 cents now. That's with historic low inflation levels of 2.4%. Inflation forecasts indicate that number will rise -- perhaps substantially -- over the next few years. So, investment losses from inflation could be much higher if investors don't protect themselves.