Worried About a Rise in Rates? Consider These Bond Funds

When it comes to owning bonds these days, many experts agree it's best to keep things short, as in avoiding bonds with longer durations. That's because the longer a bond's duration, the more sensitive it is to interest rate movements. So if--or should I say when--rates begin to rise from today's historic lows, bonds with longer durations are likely to lose more in value than those with shorter durations.

Some investors confuse duration with maturity, but they are not the same. A bond's maturity simply refers to the length of time until the bond matures, which is to say until it no longer pays interest and the investor's principal is returned. Average duration is a more complex metric that factors in interest-rate movements and other variables. For more on the distinction between maturity and duration, see this article. 

As a rule of thumb, for every year of a bond's duration (or average duration in the case of a bond fund) it can be expected to gain or lose 1% in value depending on the direction of prevailing interest rates. So a bond fund with an average duration of 5 years could be expected to lose 5% of its value for every 1% increase in rates. (Of course, part of this loss will be offset by the bond fund's yield, so if this same bond fund yields 3% the actual negative return would be closer to 2%.) This metric works better for some bond types than for others, however. Duration tends to best reflect the interest-rate sensitivity of bonds that closely track U.S. Treasuries. For those that don't, including some lower-quality corporate bonds, duration can be a useful measure of relative interest-rate sensitivity between two bond types but may not reflect their sensitivity relative to Treasury yield changes. 

The Federal Reserve has promised to keep interest rates low until unemployment reaches 6.5% (it currently stands at 7.7%). At last month's brisk hiring pace it's estimated that the economy would reach 6.5% unemployment in April 2014. Whenever rates do start to rise, bonds with longer durations are almost certain to feel the sting more than those with shorter durations (remember that bond yields and prices move in opposite directions, so an increase in today's yields for new bonds makes bonds issued previously and that carry lower interest rates less valuable).

Even if (when) rates do begin to rise, sticking with bond funds might still make sense for many investors--especially retirees and pre-retirees leery of exposing too much of their nest egg to the volatility of stocks. And so, too, does paying attention to your bond fund's duration make sense. Fortunately, Morningstar's  Premium Fund Screener tool can help.

Although short-term bond funds are an obvious starting point for investors leery of interest-rate risk, the intermediate-term bond category offers the higher yields that many income-hungry investors crave. In addition, many short-term funds have little flexibility to adjust their interest-rate sensitivity, whereas many offerings that land in the intermediate-term category have broad latitude to adjust their interest-rate, credit quality as well as sector exposures. Thus, intermediate-term vehicles can be ideal core fixed-income holdings.

We've screened on intermediate-term bond funds with below-average effective durations for the category (currently 4.8 years). Bear in mind that bond-fund portfolios can turn over quickly, so the duration reported by a fund a few months ago may not be its duration today. To ensure these funds have been vetted for management quality, process, and other factors, we'll include only those with Bronze or better Morningstar Analyst Ratings. And we'll exclude institutional funds and funds that charge loads, though Premium Members who wish to change any of these parameters may do so. Finally, we'll stick with funds that are open to new investors and with minimum initial purchases of $10,000 or less. Premium Members can see the full screen  here. The funds below are from this list.

 Scout Core Plus Bond (SCPYX)   
Average Effective Duration: 2.4 Years    
This fund's average duration stood at 4.5 years in January 2012 but has since been reduced considerably as its management team has focused on corporate bonds with maturities of 5 years or less. Miriam Sjoblom, Morningstar's associate director of fund analysis, says the fund's management team is characterized by its nimbleness and embrace of market volatility "as a harbinger of opportunity." Despite the rough patches inherent in this approach, the fund has delivered top 11th percentile annualized return during the past three years. The investor share class, available to no-load investors, was incepted in late 2009.

 Fidelity Intermediate Bond (FTHRX)   
Average Effective Duration: 3.9 Years    
Fund manager Rob Galusza's risk-conscious approach focuses on pockets of relative value in certain sectors, individual names, and segments of the yield curve, with a contrarian bent at times. The fund's corporate stake has been trimmed, but still stands at about 42% of the portfolio, well above the category average but with an emphasis on shorter maturities. Treasuries, at 27%, are nearly double the fund's peer group. The fund's conservative profile has led to underperformance in recent years versus its less risk-averse peers--its one- and three-year annualized returns all land in the bottom third of the category--but it has also helped the fund deliver less volatility than the category average. At 0.45%, annual fees are low for a no-load intermediate-term bond fund.

 USAA Income (USAIX)     
Average Effective Duration: 3.1 Years    
A recent management change shouldn't rock the boat at this fund, says Morningstar fund analyst Shannon Kirwin. New managers Matt Freund and Julianne Bass, who also manage the fund's more adventurous sibling, the 5-star USAA Intermediate-Term Bond (USIBX), aim for a smoother ride here. U.S. corporate bonds make up 38% of the fund's portfolio, according to the fund company's website, which is above the category average. U.S. government bonds make up just 12%, below the category average. The fund often holds larger stakes in credit-sensitive BBB rated corporates than its peers, along with small positions in high-yield bonds. The fund has consistently delivered above-average returns for the category and carries an expense ratio of 0.59%, which is below-average for the no-load intermediate-term bond category.

Portfolio data as of Jan. 31 for Scout Core Plus Bond and Fidelity Intermediate Bond and as of Feb. 28 for USAA Income;performance data as of March 18.

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