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By Christine Benz | 05-10-2011 09:58 AM

Which Defense for Rising Rates?

Morningstar's Eric Jacobson sizes up some common tactics that active bond fund managers and investors are pursuing to protect against rising interest rates.

Christine Benz: Hi, I'm Christine Benz for

With the threat of both rising interest rates and rising inflation looming large, many bond investors are rightly concerned about what the future holds for their bond portfolios.

Here to discuss what to look for as you conduct a checkup of your bond portfolio is Eric Jacobson; he's Morningstar's director of fixed-income research, and he's on the phone with me today.

Eric, thanks so much for being here.

Eric Jacobson: Hi, Christine. Glad to be with you.

Benz: So, Eric, I think a lot of investors are keenly attuned to this notion of having a bond portfolio that's not fighting the last war. So, we've been through a couple of decades' worth of declining interest rates, which has provided a tremendous tailwind for bond investors. What are the key themes they should be thinking about as they assess their portfolios right now?

Jacobson: I think a lot depends on how folks reacted after the crisis. Those who have done really well with their bond portfolios more than likely either piled into things that had a lot of risk or hung onto things that did through the crisis and after the crisis to make it back, there are a lot of people anecdotally we know who got onto the sidelines entirely…

Benz: So, sitting in cash?

Jacobson: In cash, absolutely. It's a little hard to tell, certainly, because the flows in the last couple years have been gigantic into bond funds. So I think we've got a lot of different stories out there, different people, and I think the most important thing is for each of those groups to kind of rethink where they are now, as I think you're suggesting.

Benz: So, you want to be diversified obviously across different bond market sectors. How about interest rate sensitivity? I've talked to some investors who have said--and we've talked about this strategy in the past--"maybe I should just hunker down in cash until this whole rising rate thing blows over." What do you think about such a strategy?

Jacobson: I get a lot of pushback on this, but I think it's kind of a dangerous idea, if for no other reason than there really isn't anything to make in cash right now, as you know, because short-term rates being held very low by the Fed are so low that if you sit around in cash and we have any inflation whatsoever, your so-called real return, in other words that's your return after the effect of inflation, are going to be negative, and you're going to lose purchasing power.

And although that may seem kind of trivial in a short period of time, we really don't know when short-term rates are going to go up. We've gone back and forth over the last couple years in terms of the signals that we've been getting from the marketplace, because economic growth has gone up and down, and we also don't know quite what's going to happen after the effect of "quantitative easing" rolls off and so forth.

There is good reason to think, in fact, that if we slip a little bit later in the year in terms of the economy that the Fed could keep rates very, very short for a lot longer.

So, hanging onto cash could really be a drain on your portfolio.

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