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By Christine Benz | 12-15-2010 10:09 AM

How Actively Should Bond Investors Shield From Rising Rates?

Morningstar's Eric Jacobson outlines the pros and cons of going to cash, seeking opportunistic bond funds, and investigating bank loans.

Christine Benz: Hi. I'm Christine Benz for How active should investors be in trying to protect their portfolios against the threat of rising interest rates?

Here to discuss that question is Eric Jacobson. He is director of fixed-income research for Morningstar.

Eric, thanks so much for being here.

Eric Jacobson: Glad to be with you.

Benz: So, Eric, over the past month, month and a half, investors have been really spooked about what's been going on in the bond market, and I've been hearing from users about some strategies they're considering.

One in particular--and certainly on the surface to me it doesn't sound like the worst idea I've ever heard--investors are saying, well, why don't I take this portion of my portfolio that I had allocated to fixed income, move it into cash until this threat of rising rates blows over?

What's your take on that question, on that strategy?

Jacobson: I think it's pretty tempting, and I think especially so because we've heard a lot of anecdotes from people who said that they did that in the past couple of years at different times and were really successful.

There's a couple of big ones dangers. One is that you miss out when the market rallies at some point, and you miss a big chunk of those gains that otherwise carry someone else for the rest of the year.

Benz: So, I guess the question is, though, right now, I look at the yield on my intermediate-term bond, fund versus cash, not a big opportunity cost there, right? I mean, what am I giving up?

Jacobson: Well, at the moment, it looks like that, but there's a couple of things. One is that, right now, the yields on ... a real basis, in other words, after inflation, are negative. So, if in fact, the simulative effects of the various government programs and tax bills that we're seeing right now, if they're successful, we have inflation, even a few percent, that's actually going to be a net loss to your cash portfolio.

So, I'm not saying that it's a horrible idea. I wouldn't want to tell people that are trying to manage their risks, not to take risk off the table. And I wouldn't say it's a horrible idea to do it on a modest basis if you're absolutely determined to sleep better at night.

But I would also say, take a look at the bond funds that you do hold, take a look at what your options are, and try to stand back and make sure that you are looking at this open-eyed. And what I mean by that is that some of your managers may already be doing some of this for you.

They may either be holding some cash, or they may have already taken some of that rate risk off the table, and they may be looking at areas where they think, for example, they are not losing opportunity cost, because they are holding something that has enough yield, that day in, day out, over the course of the year, even with little volatility, it is still going to produce a reasonable after-inflation return.

Benz: So, it sounds like you're saying an alternative to getting really active yourself is saying, well, here I've got this team at PIMCO, or Met West, or whatever it might be, they are thinking about this stuff, why I don't let them engineer this for me.

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