This bond strategy can protect your portfolio even if interest rates go up

By Mark Hulbert

A little-known investing formula shows exactly how long to hold bonds to neutralize interest-rate hikes

Several investment strategies aim to insulate a bond portfolio from rising rates,

Investment-grade corporate bond funds should produce an attractive return in the next few years - even if interest rates rise significantly.

These corporate bonds are trading at attractive yields. The iShares Core U.S. Aggregate Bond ETF AGG, the largest broad-market fund that invests in investment-grade U.S. bonds, has a 30-day SEC yield of 4.46%. That represents a real (inflation-adjusted) yield of about 2.0%, given the Cleveland Federal Reserve's current inflation expectations model.

Meanwhile, U.S. stocks are so overvalued that they may very well lag inflation over the next decade. Investment-grade bonds may actually outperform equities in the coming years.

How can bonds produce attractive returns even if rates rise, given that higher rates mathematically translate to lower bond prices?

The answer is a bond ladder, which is what almost all bond index funds do. With this strategy, higher rates won't cause performance to suffer - provided you hold for a sufficient number of years. In that event, your performance will be equal to your bond fund's starting yield.

The research that discovered this truth about bond ladders was first presented in a 2015 article, "Bond Ladders and Rolling Yield Convergence."

A bond ladder is a portfolio of bonds of different maturities that maintains a stable duration target. (A bond's duration reflects its sensitivity to changes in interest rates.) Whenever a bond matures, a replacement bond is purchased with the requisite duration so that the overall ladder's duration remains relatively unchanged.

According to the authors of this 2015 study, a bond ladder's return will closely match its starting yield, provided it is held for one year less than twice its duration target - regardless of how interest rates behave along the way.

Consider the iShares Core U.S. Aggregate Bond ETF (AGG), which has maintained a stable duration target of between five and six years. Per the researchers' formula, therefore, holding this ETF for between 10 and 11 years should immunize it from interest rate hikes.

That has largely been borne out by performance over the last 10 and one-half years, during which investment-grade interest rates have more than doubled. AGG's 30-day SEC yield in December 2015 was 2.0%, versus 4.46% today. Its return since then has been 1.8% annualized - quite close to its starting yield.

When it comes to longer-term bonds, the analysts' formula requires an even lengthier holding period. The Vanguard Long Term Corporate Bond ETF VCLT, for example, has a duration target of around 12 years. To ensure that your long-term performance with this ETF will be equal to its current yield of 5.9%, regardless of what interest rates do along the way, you would need to hold it for 23 years.

Interest-rate hedged bond ETFs

What if your investment horizon is shorter than 10 years? There still is a way to insulate your bond portfolio from rising rates, courtesy of rate-hedged bond funds or ETFs. But there's a catch: The derivatives that rate-hedged bond funds use to hedge against interest rate fluctuations are not free.

The iShares Interest Rate Hedged U.S. Aggregate Bond ETF AGRH is a good example. Its portfolio is identical to the AGG ETF but adds an overlay of an interest-rate hedge. Its current 30-day yield is 3.7%, versus 4.46% for the unhedged ETF. That difference is a good estimate of what the interest rate hedge will cost you.

The bottom line? Fear of higher interest rates is not a good reason to avoid investment-grade bonds. There are ways to immunize yourself from those higher rates, either by using hedges or holding for a long enough period.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

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-Mark Hulbert

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