INCLINE VILLAGE, Nev. - For the last decade, bonds have been a great place to be as interest rates have fallen to multi-decade lows. As a result investors have poured into bond funds. But what will happen when begin to rise? Watch out.
Low yielding bond funds, especially those investing in Treasurys, are vulnerable to rising rates. When rates rise bond prices fall. Worse yet, unlike individual bonds, which will be re-deemed at maturity, bond funds never mature. That means investors buying today can incur portfolio losses that will last for many years. In a rising rate environment it is far better to hold individual bonds, because you'll know exactly what they will be worth at maturity.
By looking "outside the box" you can find income securities that will benefit from a rising rate environment. An example is a bank loan fund. Because the loans "float," their interest rate re-sets every few months. The rate is tied to the London Interbank Offered Rate (called LIBOR). The Power Shares Senior Loan Portfolio ETF (BKLN) and Eaton Vance Floating Rate Trust (EFR) are good ways to invest in this market. They yield 4.8 percent and 6.5 percent respectively.
An asset class that will benefit from higher rates is adjustable rate preferred stocks. My favorite is HSBC Adjustable Rate Series D. This investment grade security is tied to the Treasury market. It currently pays 4.4 percent and its dividend will increase when Treasury rates rise significantly.
Another attractive adjustable rate preferred is the Goldman Sachs Series D. It currently yields 4.8 percent and is rated just below investment grade. The strength of the Goldman Sachs common stock implies a very low credit risk. This security is tied to LIBOR and went ex-dividend on the 23rd.
Bond prices won't plunge tomorrow and the Fed has said rates will remain low for years. Still, there is more room for them to move higher than lower and bond fund shareholders are facing an increasing risk. I've already begun moving client funds to securities that benefit from higher rates.
After all, higher rates will come. It's not a matter of "if" - it's a matter of "when."
- David Vomund is an Incline Village-based fee-only money manager. Information is found at www.ETFportfolios.net or by calling 775-832-8555. Clients hold the positions mentioned in this article. Past performance does not guarantee future results. Consult your financial advisor before purchasing any security.