(PUB) Morningstar FundInvestor

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Safeguard Your Bond Portfolio Portfolio Matters | Christine Benz

short-term bonds would likely be much less vulner- able in a period of rising yields. Using a duration stress test, the typical intermediate-term bond fund would stand to lose about 3% of its value if interest rates jumped up by 1 percentage point over a one- year period; the typical long-term fund would lose about 9% or even 10% . The average short-term fund, meanwhile, would lose about 1% , and cash ( CD s, money market funds, and so on) would remain stable. The Risks: As investors who shortened up a few years ago know well, there’s an opportunity cost to hunk- ering down in ultra-low-yielding cash and short-term bonds. Even though interest-rate jitters were alive and well three years ago, the typical intermediate- term bond fund has gained more than 1 percentage point more, on an annualized basis, than the average short-term bond fund since early 2011 . That risk is arguably more in the rearview mirror than it is a con- cern on a forward-looking basis. A bigger consider- ation, however, is how to know when to get back into intermediate-term bonds once you’ve exited them. After rates have risen 3 percentage points? Four? More- over, Morningstar senior fund analyst Eric Jacobson says that cash and/or short-term bonds, even high- quality ones, may not provide the same ballast for the equities in one’s portfolio as intermediate- or longer- term bonds tend to do. True, short-term bonds won’t tend to go down much, if at all, in an equity-market shock, but neither are they likely to gain value during such a period, either. Buying Individual Bonds The Strategy: Forget bond funds. What about simply buying and holding individual bonds to maturity? Whereas the holder of a bond fund could incur prin- cipal losses if interest rates go up during a given holding period, the investor in a high-quality bond would receive his or her principal value back, even if yields jumped up substantially during that period. The Risks: As with shortening up, the investor in indi- vidual bonds faces potential opportunity costs. By locking in today’s relatively low rates, the individual- bond investor who’s buying and holding won’t have the opportunity to swap into higher-yielding bonds if

Given that they’re often considered the safe, boring part of investors’ portfolios, bonds have certainly produced more than their fair share of angst during the past few years. Having enjoyed the tailwind of declining yields for nearly three decades, many bond investors have been fretting about the day when that tailwind would become a headwind. Those fears were stoked in the summer of 2013 , when Federal Reserve chairman Ben Bernanke hinted that the Fed could begin to scale back the bond-buying program that had suppressed bond yields since the financial crisis, and consequently provided a glimpse of what a period of rising rates could mean for bonds. Not surprisingly, long-term Treasury bonds took it on the chin, dropping 6% during the second quarter and shedding another 6% in the second half of the year. Categories such as emerging-markets bond funds proved quite rate-sensitive, too. Against this uncertain backdrop, investors have been mulling—and executing—a variety of strategies to help protect their portfolios against rising bond yields. Morningstar’s fund flow data show that they’ve been shortening up, embracing credit-sensitive bonds, and eschewing bonds altogether in an effort to defend their portfolios against rising rates. Yet even as such strategies might seem eminently sensible given that bond yields have much more room to move up than they do down, all of these tacks carry drawbacks of their own. Here’s a rundown of the key benefits and pitfalls of some of these strategies. Shortening Up The Strategy: At first blush, the notion of moving into cash or short-term bonds in lieu of more rate- sensitive securities looks like the biggest no-brainer out there. Rising interest rates have the potential to crunch long- and intermediate-term bonds, whereas