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How Actively Should Bond Investors Shield From Rising Rates?

Christine Benz

Christine Benz: Hi. I'm Christine Benz for Morningstar.com. 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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Jacobson: That's right. Now, I'm certainly saying this within the context to keeping an eye on your overall risk, and I'm not suggesting that people throw out one risk in exchange for another entirely, but some of the things that your core managers have been doing, for example, are finding pockets of the market that are little less efficient or maybe have a little more credit risk in an environment where they think that that's fine because the default rate is low and has being going bit lower, where they think that, if there are good effects from the stimulus, these issues will hold up better, and they're exchanging some of that interest rate risk for a little bit more credit risk, a little bit more income, but within the broader context of a risk framework.

That kind of describes a lot of those intermediate funds that are kind of benchmark focused, and are still going to have some interest rate exposure. There are a few funds out there that have been becoming more popular, and I really caution people not to just jump right in any of these, but, there is a few of them that have names like Strategic Income Opportunities, a really good JPMorgan fund with that name for example. There is one called PIMCO Unconstrained Bond.

They are different, they're not identical. The JPMorgan fund is much, much more risk averse in some ways, and the PIMCO Fund is a little bit more active, but the idea there is, they generally throw out some of the benchmark requirement of sticking to an interest rate sensitivity consistent with the rest of the market, and they give the manager the freedom to move in and out, both in terms of interest rates and lot of sectors. I'm a real big fan of the PIMCO Fund, mainly because of the history that that manager ... a fellow by name of Chris Dialynas ... has with PIMCO for a number of years. He's not a household name, but he's drawing off of a really, really skilled set of colleagues there.

Benz: So, that's PIMCO Unconstrained Bond?

Jacobson: That's right.

Benz: So Eric, you were also talking to me about bank loan funds for at least a slice of an investor's portfolio. Let's talk about that category. It's one that has a really attractive feature in that it has some imperviousness to rate fluctuations. Let's talk about what you like there.

Jacobson: Absolutely. Now, the thing to keep in mind here is that, we're in this sort of back and forth kabuki dance between the Fed and the market right now. And at the moment, we're in a place where the Fed has signaled that it's not going to raise short-term rates for a long time. So, the markets are not expecting short rates to go up anytime in 2011, which means that you are probably not going to see a nice rally in the income from bank loan funds…

Benz: And they have already rallied quite a bit, right?

Jacobson: ...And that's been more of a credit rally, right. I am sorry, what I mean to say is, you are not going to see a big spike in the income that they throw off. However, if rising rates are your main concern, and again, we'll see how the market goes and how the Fed speaks. If the Fed starts to see inflation ticking up, those expectations may change, but the main idea behind bank loan funds is that the loans that are in those portfolios offer a spread of income above the short-term rates.

Technically speaking, we are talking about LIBOR, the London Interbank Offered Rate, but it tends to go with Fed funds. So, if the Fed, and when the Fed, whenever that is, starts to hike short-term interest rates, those loans are not going to see the kind of interest rate volatility that so many other parts of the market will. Their income will actually ratchet up at the same pace that Fed funds moves.

The risk, of course, on the other side is, these loans are fairly credit sensitive. Even though they are very structurally sound, in a sense that they give you some of the best security you can have within the capital structure of a company. So, the company has to pay these loans off first usually, and most of them are secured by pretty significant assets.

There still is credit risk, because they tend to be lower quality, below-investment-grade companies, but in this environment, where we don't have a lot of default risk at the moment, where we think the economy is going to be doing reasonably well, where we think at some point maybe there is a risk of rising rates, if you as an investor are particularly concerned about that, that may be a place to consider.

Again, depending on where we are in this Fed cycle, we probably have little bit more time, but you don't want to wait until the last minute either, because usually what winds up happening is, as soon as the market perceives that rates are going to start to tick up, huge flows tend to come right into this category. It will drive prices up, and you will have missed out on some of the potential cushion that you could have had in their prices. Again, though, don't look at the yields today and expect that that's going to be your return, because they are going to very, very sensitive to how Fed funds moves.

Benz: So, I assume you have a favorite or two in that category as well?

Jacobson: In that category, I do, certainly, but there are some flavors that you want to consider, and they really run the gamut all the way from some of the most conservative, and not only in terms of credit quality, but in terms of structure, and Fidelity has a few funds that – which you want to consider

Benz: The Floating Rate [High Income] Fund…

Jacobson: Right, what they do is they tend to focus on bigger issues, more liquid issues; they tend to hold a little more cash, and you can get your money out every single day, which is quite common. There are few funds like that, but they are one of the first. They tend to be one of the most conservative daily liquidity funds.

You also have a series of funds that are called continuously offered closed-end funds. People often hear them referred to as interval funds. They may have a monthly tender option or a quarterly tender option, which is really important. It means that it's possible in a crunch that you might not be able to money out, but a lot of people have held those, and they tend to take on a little bit more risk in terms of the underlying portfolio, usually have a little bit leverage, which can be okay in a good market environment, especially when its linked to LIBOR like this, because you don't have the big leverage risks in terms of income gaps that you can find in other places.

The next step, of course, being closed-end funds, and there are a handful of those, where they also use a bit more leverage. Tend to be a lot of the same teams running them across the board. So, you have a lot of choices there, but in some of those spaces, I would look at Eaton Vance, they are pretty good at it, again Fidelity. And there are handful of up-and-comers, where they haven't been known for it as long, but teams that had been running money in the bank loan space, maybe institutionally, now have some open-end offerings.

Benz: Okay. And here again this is a category where you wouldn't say, well, it should supplant your whole fixed-income allocation, you want to do it kind of around the margins of your portfolio?

Jacobson: That's right. And I think – I suggest people think of it as being a step-in perhaps from high yield, but pretty closely related. So, there is going to be a meaningful credit risk there, and liquidity risk in the event that we have some sort of big market shock in any particular month.

Benz: Okay. And we saw that on display in '08 for sure in lot of these funds, okay.

Jacobson: And the good news, of course, they bounced back pretty strongly, but that was a big, big liquidity challenge.

Benz: Okay. Well, Eric thanks so much for sharing these ideas. We appreciate it.

Jacobson: Glad to be with you.

Benz: Thanks for watching. I am Christine Benz for Morningstar.com.