ALBERT HERTER

‘GET AHEAD OF RISING RATES—BEFORE THEY GET AHEAD OF YOU,’ at fidelity.com.

In Uncategorized on January 7, 2010 at 06:05

Get ahead of rising rates – before they get ahead of you

BY ROGER FILLION,  FIDELITY INTERACTIVE CONTENT SERVICES — 01/04/10

Bondholders face risks if interest rates rise, but that doesn’t mean it’s time to bail out of fixed-income investments that provide a steady income. Here are steps to protect yourself.

Spooked by the global financial crisis, investors poured a record $300 billion-plus into the safety of bond mutual funds last year.

If you were one of them, consider this: Interest rates are low now, but gaping federal budget deficits and the recovering economy are likely to put upward pressure on rates over the next few years. That means prices in the bond market are likely to fall since bond prices and bond yields move in opposite directions.

“Bond fund flows have been through the roof this year,” Todd Burchett, manager of ICON Bond Fund (IOBIX | at ICON Advisers in Greenwood Village, Colo, said in December. Investors have benefited, with many of the funds posting positive returns during 2009. But preserving those gains would be more difficult if rates rise.

Not that you should run out and dump all of your fixed-income investments. It could be some time before rates make a big move. But there are steps you can take now to minimize the impact if they do.

“It’s a time for investors to be concerned about higher rates,” said David MacEwen, chief investment officer for fixed income at American Century Investments in Kansas City, Mo.

Diversification can go a long way toward offsetting some of the pressures we may be seeing in the bond market.

CHRIS SHARPE, CO-MANAGER, FIDELITY STRATEGIC INCOME FUND

Time to think ahead

Recently, the bond market gave a classic signal that interest rates are likely to rise. Longer-term bond yields climbed during December, pushing the “yield curve” – which charts the difference between yields on short-term and long-term government debt – to its steepest level ever. A steep curve is a sign that investors believe the economic recovery is for real – and that interest rates are set to start rising.

The question, of course, is when. As we just noted, rates in the bond market have already started rising. But most experts don’t expect the Federal Reserve, the nation’s central bank, to start raising official interest rates until the second half of 2010, or perhaps not until 2011.

“Longer term, we see rates going up on a (sustained) basis,” said Matt Eagan, co-manager of Loomis, Sayles & Co.’s Bond Retail fund (LSBRX | in Boston. “We think we’re at an inflection point.”

That means now is the time for investors to take steps to safeguard their bond portfolios against the expected rise in rates. One way to do this is to invest in diversified bond funds that include inflation-protected securities, international bonds and other income-producing investments.

Individual bonds, by comparison, become less attractive as rates rise. They can provide steady income in a well-diversified portfolio but unless you plan to hold them to maturity, this is not a great time to buy them.

“Diversification can go a long way toward offsetting some of the pressures we may be seeing in the bond market,” said Chris Sharpe, co-manager at Fidelity Strategic Income Fund (FSICX ) )))) I OWN A BUNDLE OF THIS  AND FIVE TIMES AS MUCH OF SPHIX–FIDELITY HIGH INCOME.

So if you’ve stocked up on bond funds over the last year, here are some steps you can take:

TIPS: The U.S. Treasury issues Treasury Inflation-Protected Securities. The principal is adjusted up or down every six months to reflect changes in the government’s chief inflation gauge, the Consumer Price Index. No one purchases these securities for their yield, which now is at just over 1%. People buy them as a hedge against rising inflation.

While TIPs pay a fixed interest rate, your interest payment can vary over time depending on whether the principal has been adjusted up or down. At maturity, you receive the adjusted principal or the original principal, whichever is greater.

“Investing in them right now is kind of like buying insurance for the future,” said Diahann Lassus, president of Lassus Wherley & Associates, a fee-only financial planning and investment management firm in New Providence, N.J. The Treasury’s TreasuryDirect program allows you to buy TIPS directly from Uncle Sam.

Many mutual funds and ETFs invest in TIPS as well as other securities to get the best of both worlds: A hedge against inflation from TIPS and a stream of income from other debt securities. Total income or strategic income-managed funds use this strategy.

Floating-rate mutual funds: These funds own certain types of corporate bonds, floating-rate bank loans and other debt securities whose yields fluctuate, so you enjoy more income if rates rise. They also tend to pay a yield well above government bond funds – but they also are riskier.

“If rates rise, they become a very compelling investment,” said Burchett of ICON Advisers.

Companies use some of these securities, which can be likened to adjustable-rate home mortgages, to raise cash. But like in the mortgage market, the securities are only as good as the credit of those repaying the loans. They do not have government backing.

Because floating-rate securities carry more risk than other types of fixed-income securities, investors should be wary about picking them on their own. Mutual funds and other investment funds, by contrast, rely on investment professionals and research staffs to sort through the offerings for the safest high-yielding issues.

Short-term bonds or bond funds: Another strategy to prepare for the onset of higher rates is to move to shorter-term investments with maturities of one to five years or so.

Investing in fixed-income securities with shorter maturities or funds that invest in them doesn’t mean settling for the near-zero rates of Treasury bills or money markets. There are high-yield corporate securities and shorter-dated bonds issued by government-sponsored agencies such as the Government National Mortgage Association. With such securities you can find yields that are twice or more than what money markets and T-bills pay.

Most important, if you keep your funds in short-term securities you will have money left so you can trade up to higher yields when they arrive.

“If there is a change in interest rates, there won’t be as significant an impact on the price of your bonds,” said Robert Wacker, president of R.E. Wacker Associates Inc., a fee-only investment advisory firm in San Luis Obispo, Calif. “They will be maturing sooner and thus available for investment at the higher rate.”

International bonds and bond funds: Putting money in overseas corporate and government bonds can protect you against rising U.S. interest rates and inflation.

Many expect the dollar to fall.  With this in mind you can devise an inflation-beating strategy. Here is how: As the dollar falls, your fixed-income investments from other currencies rise in dollar terms. So your yield on those investments rises.  It’s one reason why so-called total income funds or strategic bond funds like to boost yield by keeping a mix of foreign and emerging market bonds in their portfolios.

“The dollar is at risk of a long-term decline. That’s the reason to own (investments denominated in) foreign currencies,” said American Century’s MacEwen.

Equity income funds and high-yielding stocks: Equity income funds, usually more conservative than most typical stock funds, invest in high-quality companies with good track records of paying attractive dividends. While the past year has seen many companies slash their dividends, payouts could begin rising again as the economy recovers, though the rebound is likely to be slow.

One way to capture this yield is to buy individual stocks paying a rich dividend. Another is to look for mutual funds that invest in dividend-paying stocks. With funds, you have the advantage of professional stock pickers who study the companies most likely to raise dividends.

If you’re looking for current income, a stock with a higher dividend yield “will provide greater income than bonds,” said Wacker. He cited Merck & Co.  as an example. The stock currently yields 4% while the 6-year bond yields 2.9%.

But analysts also warn of the risks. Stock prices rise and fall and dividend payments aren’t guaranteed.

No one can predict the path of interest rates with any certainty. But with a bit of diversification you’ll be better prepared if rates rise – and for other contingencies as well.

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