Still Worried About Rising Rates? These Funds Can Help
A handful of intermediate-bond funds are among the best in their category while having lower sensitivity to rate movements.
Our Picks
Last year around this time bond investors were in a tizzy. After a long bull run on bonds, punctuated by some of the lowest interest rates on record and the Fed's aggressive bond-buying stimulus program, fixed-income investors had become a nervous lot.
Sure enough, rates shot higher throughout the summer as investors rushed to front-run the beginning of the end of the Fed's program, also called the taper. The actual taper wouldn't begin until January, but since then a funny thing has happened: Interest rates have actually declined, with the 10-year Treasury sliding from 3% at the start of the year to today's 2.7%.
This recent decline has been a boon for investors who have stuck it out with long-term bonds, which typically are the most sensitive to interest-rate fluctuations. (Remember that rates and the value of existing bonds move inversely to each other, so a decrease in current rates makes bonds that pay higher rates more valuable, especially if they pay those rates during longer time periods.) On the heels of a 13% loss in 2013, the long-term government-bond category has rebounded so far this year, with a 9.6% average gain as of May 12. This recent performance is a lesson in the unpredictability of interest-rate movements, but the consensus seems to be that rates are due to rise in the coming years.
Short-term bonds are still the surest way to protect a portfolio from interest-rate movements but continue to yield in the neighborhood of 1%, which won't even keep pace with inflation. For investors looking for more yield but unwilling to go all-in with a long-term bond fund that could get hammered if rates do rise sharply, an intermediate-term bond fund is a good middle-ground alternative.
One way to measure the interest-rate sensitivity of a bond or bond fund is by looking at its duration (or average duration if discussing a bond fund's portfolio). As a rough rule of thumb, for every percentage point that interest rates rise, a bond or bond fund can be expected to lose a percentage of its value equal to its duration, less its yield. Thus, if rates rise 1%, a fund with an average duration of 5 years might be expected to lose 5% of its value. However, if the fund yields 3%, this helps offset the loss, making the total loss closer to 2%. Keep in mind also that duration is most useful when measuring interest-rate sensitivity for bonds that closely track the Treasury market.
Many bond-fund managers have already shortened the durations of their portfolios in anticipation of the taper and rising rates. In fact, the average duration for intermediate-term bond funds stood at 4.9 years at the end of March. By comparison, the average effective duration for the Barclays Aggregate Bond Index stood at 5.7 years. (Of course, preemptively shortening durations while rates have continued to go down in recent years may actually have hurt the performance of these funds relative to those that kept them on the longer side.)
To identify intermediate-term bond funds with durations below the category average, we turned to Morningstar's Premium Fund Screener tool. We limited our search to funds with Morningstar Analyst Ratings of Gold, Silver, or Bronze to ensure that only the highest-quality funds were included, and we excluded funds that are closed to new investors or only available to institutional investors. Premium Members can click here to read the full list (which includes multiple share classes of some funds). The funds that follow are examples from the list.
Loomis Sayles Investment Grade Bond (LIGRX)
Although not as adventurous as sibling Loomis Sayles Bond (LSBRX), this fund has plenty of flexibility. It invests up to 10% of assets in below-investment-grade bonds, 20% in non-U.S. bonds, and up to 10% in equities. Its experienced management team uses a value-driven, credit-intensive approach, targeting securities they believe are undervalued and positioning the fund with an eye toward limiting interest-rate exposure. The fund can be volatile--it lost 11.6% in 2008--but is a long-term top performer, with 10-year annualized returns in the top 1% of the category. "For those with a long time horizon and the stomach for volatility, this remains a strong choice," writes Morningstar analyst Sarah Bush. This fund may carry a sales charge, or load.
Metropolitan West Total Return Bond (MWTRX)
This fund is run by value investors looking to buy bonds when they're fundamentally cheap and sell them when they get expensive. Its managers will actively adjust the fund's duration relative to the Barclays Aggregate Bond Index. High-yield corporates and nonagency residential mortgages have figured prominently here, which can result in a more aggressive credit profile than the category norm. The fund's 6.9% annualized returns during the past 10 years beat the intermediate-term bond category average by more than 2 percentage points.
TCW Total Return Bond (TGMNX)
MetWest veterans Bryan Whalen and Mitch Flack have run the fund since late 2009 and keep the focus on agency and nonagency mortgage-backed securities. The fund mostly avoids Treasuries (just 14% of the portfolio as of March 31) and has long remained cautious of interest-rate risk. The fund's sizable nonagency position exposes it to significant credit and liquidity risk, which could hurt in a broader flight to quality or if the housing market weakened, says Morningstar's Michelle Canavan Ward. The fund has been a top-decile performer in its category during the trailing three-, five-, 10-, and 15-year periods. It also has been a particularly good performer in both up and down markets.
Performance data as of May 12