Curbing Interest Rate Shock

What are the best bond investing strategies for retirees amid rising interest rates? There are two. I like to call them the “stuff in between” strategies, because they fall between bonds (whose values are vulnerable to rates increases) and stocks (usually not affected).

As the economy gradually recovers, the Federal Reserve keeps hinting at increasing rates. While higher rates are not a bad thing for retirees who invest primarily in bonds, traveling into that territory can be treacherous, and calls for some careful planning.

When rates rise, bond funds and bonds with long maturities and low interest rates suffer the most. The decline in value could wipe out years’ worth of gains. I have addressed this risk for a couple of years now by moving the portfolios away from longer-maturity lower-yielding securities, shortening the maturities of the core bond exposures while adding highest quality corporate junk bonds in the mix for higher yields.

Many investors take a barbell investment approach with bonds and cash on one end, and stocks on the other. But putting some stuff in between potentially produces rewards that are greater than bonds and with less risk than stocks.

Here are my two stuff-in-between strategies that I believe can hold up well in amid increasing rates:

1. Long-short bond funds

These funds look to invest in bonds and other fixed-income investments while hedging against rising rates. I currently use two funds to accomplish this: Driehaus Active Income (LCMAX) and Driehaus Select Credit (DRSLX).

One strategy that Driehaus employs is buying longer-term corporate bonds to take advantage of the higher yields, and shorting Treasuries with a portion of the portfolio.

Shorting a bond is a hedge against rising interest rates. You borrow bonds from a lender and sell them. If and when interest rates increase, causing the bond prices to drop, you buy the bonds back and return them to the lender. By adding this short Treasury position to the mix, the portfolio has some protection against falling bond prices.

Over time, I hope to see this investment achieve half the return of stocks with only one-third of its volatility, very much similar to what people expected from bonds a decade or two ago.

2. Short-term high-yield bonds

Lower-quality companies issue bonds, also known as high-yield or junk bonds, that offer higher yields for investors who are willing to take more risk. Basic high-yield bonds may be too volatile for retirees. However, shortening the duration of these bonds in a portfolio can lower the risk to a more acceptable level.

I like the Osterweis Strategic Income Fund (OSTIX) because it invests in short-term, high-yield bonds with an average duration of two years. (Duration is a measure of how vulnerable a bond is to rate increases.) Investing in those bonds with short maturities reduces volatility, but you can still enjoy a better yield than you get from bonds that higher-quality companies issue.

I hope to achieve a 4% to 6% total annual return with half the risk of high-yield bonds and one-third of the risk of stocks with this strategy.

To be sure, these strategies also carry risks. Investing in longer-term bonds comes with more interest rate risk: Their prices drop more when rates go up. And lower-quality junk bonds have more credit risk – odds are higher that they will default on interest payments.

Interest rates are hard to predict. Many economists expected rates to rise this year, but the 10-year Treasury fell from 3.04% at the end of 2013 to about 2.2% lately. As I usually say, when everyone in the market expects one thing, the opposite often happens. That’s why having a balanced approach to fixed income investing while including the stuff in between gives retirees the best shot to achieve attractive yields with less volatility.

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Written by Barry Glassman, CFP, who is the founder and president of Glassman Wealth Services, a fee-only investment management, financial planning and wealth management firm in McLean, Va. He has been honored with just about every Top Financial Advisor Award from the financial planning industry and his peers in publications including Barron’s, Investment News, Reuters, Washingtonian and Virginia Business. He is a contributing writer at Forbes.com and Investment News. Follow Barry on Twitter at @BarryGlassman. His website is www.glassmanwealth.com.

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