While Federal Reserve Chairman Ben Bernanke said Wednesday that the central bank intends to hold short-term interest rates near zero, long-term rates are already inching up. That's bad news for bond investors and worse for some fixed-income funds than for others.
The average yield on the 10-year Treasury is now hovering at 3.40%, up from 2.54% at the beginning of October. Experts expect those rates to keep climbing as the economy continues to recover and inflation fears mount. "With interest rates at or near historical lows I think it's a fair to say that interest rates are going to rise," says Jim Cavanaugh, client portfolio manager at J.P. Morgan Asset Management.
As investors well know, any rate increase will cause most bond prices to drop, as investors dump existing bonds for newer, higher-yielding ones. But some bonds are more sensitive to interest rate changes than others bonds with longer maturity, zero-coupon bonds, and issues with little credit risk. Long-term Treasurys, for example, are especially sensitive to interest rate risk because few factors other than rate movements affect their yields. Indeed, the long-term government bond fund category at Morningstar carries the most interest rate risk of any funds, with an average duration of 14.16 years. And these funds have already seen losses: The average fund lost 1.53% in the first quarter after falling 8.63% in the fourth quarter of 2010, according to the fund tracker.
But other, less-obvious types of bond funds could see big losses as rates climb, say advisers. "There are a number of types of funds that you should shy away from in a rising rate environment," says Louis P. Stanasolovich, president and chief executive officer of Legend Financial Advisors. And although money managers say it's unclear to how soon or quickly rates will climb, "it's not too soon for fixed income investors to prepare," says Cavanaugh of J.P. Morgan. Here are three varieties investing pros say investors should be wary of as interest rates rise.
Municipal bond funds
Long-term national municipal bond funds and high-yield muni bond funds are second (and third) to long-term government bond funds in interest-rate sensitivity (measured by what's called "duration), according to Morningstar. That's because muni fund managers often invest heavily in longer-dated municipal bonds to lock in more attractive yields a strategy that paid off handsomely when interest rates were falling. But the reverse is also true, says Thomas Doe, chief executive officer of research firm Municipal Market Advisors. "When interest rates rise, prices will fall, and there will be a penalty," says Doe. "You'll have greater volatility."
Some investors have already gotten pinched. The average high-yield muni fund lost 5.4% in the fourth quarter of 2010 and another 0.9% in the first quarter of 2011. That's led to massive outflows: Investors have pulled $7.4 billion out of long-term national muni bond funds from October, 2010, through March, 2011. (In the same period a year earlier, they poured $1.2 billion into the funds, according to Morningstar.)
On the other hand, that sell-off has left many municipal bonds favorably valued, says Anthony Valeri, fixed income strategist for LPL Financial. Typically, municipal bonds yield less than Treasurys because of their tax advantage, but the current yield on AAA-rated long term municipal bonds is 112% of the yield on comparable Treasurys, up from the 93% average over the past 20 years. The extra yield should help long-maturity muni funds offset some of their losses due to rising rates, says Dan Loughran, team leader of the Rochester Investment Team, which manages 20 municipal bond funds for Oppenheimer Funds.
But shorted-dated funds will hold up better, he says. "If investors only have or one or two-year time horizon they should be in a short term bond," says Loughran.
Zero-coupon bond funds
Top performers in the first half of 2010, these funds have since crashed. Zero-coupon Treasurys, which don't pay interest payments each year like regular bonds, are especially sensitive to interest rate movements, analysts say, because investors have to wait longer to get paid. Managers buy these bonds at deep discounts (often higher than 20%), and at maturity collect the principal at par value. "They are the most volatile bonds," says Stanasolovich.
American Century Investments, which manages $710 million in its zero-coupon funds that mature in 2015, 2020 and 2025, says investors should be aware of the interest rate risk tied to the strategy. Its $153 million Zero Coupon 2025 fund,
Some advisers still recommend using zero-coupon bonds to fund far off commitments, such as a child's college education, because investors can essentially lock in a yield for the life of the bond, says Valeri. That said, zero-coupon bond funds "can see some significant swings depending what interest rates do," says John Leis, vice president of personal financial solutions for American Century Investments. "If interest rates go up, these products will go down in value."
Ginnie Mae funds
Many investors seeking a slight yield advantage but low credit risk have turned to Ginnie Mae funds, which invest in mortgages backed by the federal government. But these funds are just as sensitive to interest rate risk as Treasurys, says Stanasolovich. Because of their guarantee, they offer only a slight yield advantage over Treasurys a boost that is helpful when rates are falling, but not enough of a cushion to offset price declines if rates increase substantially, he adds.
And while Ginnie Mae funds now have low durations for example, the $35.2 billion Vanguard GNMA fund,
For their part, some managers of Ginnie Mae funds say the yield advantage Ginnie Mae funds have over Treasurys would offset some of the losses from interest rate increases. Dan Newhall, principal of Vanguard's portfolio review group, points out that the GNMA fund yields 1.3 percentage points more than the Vanguard Intermediate Term Treasury fund,