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By Christine Benz and Eric Jacobson | 02-04-2013 01:00 PM

3 Gold-Rated Picks to Hedge Interest-Rate Risk

Morningstar's Eric Jacobson outlines three short-term bond funds that can protect against rate sensitivity, but mind the risks as such funds aren't cash substitutes.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With the threat of rising interest rates looming large, many investors are concerned about shielding their portfolios from excessive interest-rate sensitivity. Joining me to discuss some of Morningstar's favorite short-term bond funds is Eric Jacobson, he is a senior analyst with Morningstar.

Eric thank you so much for being here.

Eric Jacobson: Hi, Christine. It's great to be with you.

Benz: Eric, let's start by discussing the short-term bond category. I've been hearing from some of our Morningstar.com users that they are using some of these funds to stand in for their cash holdings. Is that a good strategy in your view?

Jacobson: Christine, I think the real key issue is what you said about standing in for cash. The short answer is that short-term bond funds aren't cash. Now if you are really cognizant of what they are and what they hold, then it's all right I guess to stretch out a little bit, be willing to take on a little bit more interest-rate risk in terms of what can happen over a market cycle, and more importantly, I think in many cases is understand that you're probably going to take on some credit risk that you may not otherwise realize is there, depending on the fund that you're investing in.

Benz: So you can pick up some extra income, but you probably won't have that net asset value stability day in and day out?

Jacobson: Yes, in most cases it's pretty trivial, but for people who really, really prize and value unbelievable stability, if you will, in that part of their portfolio, they do need to understand that some risk exists there. Any time you want to take a look at what your worst-case scenario might look like, you probably want to look at 2008 and see what happened to your fund in that period of time.

In most cases you're only talking about a couple of percentage points of change, but you need to make sure you're comfortable with that because that's probably about as bad as things are normally going to get in the midst of any kind of crisis.

Benz: Let's discuss this ultra-short-term bond category. We've recently seen some fairly new funds coming to market. What's your take on that category, and that's another place where investors have been using those funds to supplant cash? I'm guessing you would say that investors should really know the risks in their funds and know what they are doing before investing in them.

Jacobson: Exactly so, and part of the reason for that admonition is the fact that so many of these funds market themselves as just a step above cash but truly need to take on some additional risk in order to be viable products. And what I mean by that is they almost always charge enough that they got to hit a hurdle in terms of how much their income they are delivering just to be able to bring to you the yield that they are promising, and they've got to often take either interest-rate or credit risk to get there. So if it's an ultra-short-term fund, in particular, usually that's going to come through some sort of credit risk.

Now you may or may not be able to see it definitively based on the credit ratings, depending on what kind of securities [the fund is] investing in. So you want to take a look at the credit rating breakdown of the portfolio as well as what kind of sectors the portfolio is invested in.

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