Here are some bond funds to help dull the pain of rising interest rates.
Although far from great, the U.S. economy has shown steady signs of improvement over the past few months. In fact, we have witnessed six consecutive quarters of positive GDP growth. The unemployment rate has started dropping from a high of 10.1% in October 2009 to 8.8% today. The current positive momentum means that we are getting closer to the Federal Reserve raising short-term interest rates and stopping the open-market purchases of Treasury bonds. When this happens, interest rates of all maturities are expected to rise. Because bond prices are inversely correlated with the direction of interest rates, a portfolio of fixed-income securities will likely lose value. What can bond investors do to insulate their portfolios from principal losses?
To help insulate a portfolio from rising interest rates, an investor can look for bonds that have above-average yield and below-average duration. Bonds with higher relative yields are less affected by movements in short-term interest rates. Duration is a measure of a bond's price sensitivity to interest-rate movements, and it allows an investor to compare bonds with different maturities and coupons. For every 1% rise in interest rates, the bond's value will decline by its duration. For example, a bond with a duration of 5.0 years will decline approximately 5% with a 1% rise in interest rates.
The standard benchmark for fixed income is the Barclays Aggregate Bond Index. It currently has a duration of 5.1 years and a yield to maturity of 3.0%. The following is a list of fixed-income exchange-traded funds with above-average yield and below-average duration.
Keep in mind that these alternatives are different animals from the benchmark. Bond investing is all about weighing which risks you want to take, and these suggestions reduce interest-rate risk but add credit risk, foreign currency risk, and prepayment risk to the table.
WisdomTree Emerging Markets Local Debt
Duration: 4.8 years
ELD is an active fund that offers exposure to government bonds of emerging-markets countries denominated in their local currency. Emerging-markets debt has historically been very volatile and prone to defaults. In the past, most debt was issued in U.S. dollars because they did not have local debt markets. This exposed them to the volatile swings of their currency in comparison to the U.S. dollar. In the past 10 years, emerging countries have worked to reduce their reliance on external funding. The growing private pension systems, higher savings rates, sound fiscal policies, and more-flexible currency regimes have created internal demand for the emerging countries' government debt.
With an average credit rating of BBB, this fund sports an investment-grade portfolio with a yield of 3%, which is better than the benchmark. Also, its duration is slightly lower than our benchmark. The returns of the fund will be strongly impacted on the direction of the U.S. dollar in relation to the emerging markets. While short-term currency movements are uncertain, the longer-term trend seems to indicate a declining dollar versus emerging currencies because of the emerging markets' higher GDP growth rates and strong sovereign balance sheets.
PowerShares Fundamental High Yield Corporate Bond
Duration: 4.19 years