November 10, 2003

Bond Funds and Rising Interest Rates

Nov. 7, 2003 -- Market pundits have been warning for nearly a year that the bond market boom may be ending, but it took the summer's sell-off for investors to pay attention. In mid-August, after the yield on the bellwether 10-year Treasury bond rocketed from a 45-year low of 3.07% to 4.67%, triggering double-digit losses at the worst hit bond funds, investors began hunting for a safe haven from rising rates.

"There's a risk that a stronger economy in the new year will lead to higher interest rates," says Marilyn Capelli Dimitroff, president of Capelli Financial Services Inc., a financial advisor in Bloomfield Hills, Michigan. Even fears of a Fed rate hike might send Treasury yields higher, and bond prices into a slump, she warns.

Some investors are reacting to the summer's bloodbath by dumping bonds in favor of stock funds. But money managers and strategists note that there are a growing list of alternatives to this drastic and possibly ill-conceived response.

"If I think a 30% allocation to bonds is appropriate, I don't want to take my clients out of the asset class, or even take them much below that level," says Ms. Dimitroff.

The traditional solution, and the one Dimitroff has used with many of her clients, is to move assets into short-term bond funds. With an average duration of three to four years, any losses caused by rising interest rates -- whether due to rate hikes by Federal Reserve policymakers or to Treasury market gyrations -- will be short lived, strategists note. Many of these funds hold half or more of their assets in higher-yielding short-term corporate bonds, such as Scudder Short Term Bond Fund/S (SCSTX), recently upgraded by Standard & Poor's to a four-star ranking. Calvert Short Duration Income/A (CSDAX) holds 70% of its assets in corporate securities, and 11% in municipal bonds, while Columbia Short Term Bond Fund/B (CTBBX) keeps half in corporate securities and 25% in Treasuries. Advisors also need to monitor the duration of the funds' holdings, which can range from as little as 1 year to 3 years, and which can fluctuate.

In recent months, mutual funds have begun rolling out ultra-short funds. With durations between 12 and 24 months, the category resembles a more volatile and higher-yielding money market fund, analysts say. One of the veterans of this new crop of offerings is Fidelity Ultra-Short Bond (FUSFX), launched a year ago. The Fidelity fund maintains about two-thirds of its assets in corporate securities. Investment Management Inc. introduced Dryden Ultra Short Bond Fund (PDUAX) last April, and by Labor Day the fund had pulled in some $400 million in assets. A more recent launch was the July debut of Evergreen Ultra Short Bond Fund.

"We certainly looked at (creating an ultra-short fund) because intuitively it made sense," says Edward Wiese, senior portfolio manager at T. Rowe Price, "We decided against it, because our studies showed that you give up more return than you give up in volatility when moving from a standard short-term fund."

Rydex Srs Tr:Juno Fund (RYJUX) has seen its assets under management balloon to $840 million this year from only $94 million in January, says manager Anne Ruff, largely in the wake of the summer's bond market bloodbath. That's because the Juno fund is one of only two funds -- the other is ProFunds:Rising Rates Opportunity/Inv (RRPIX) -- that allows investors to actively bet that rising rates will hurt bond prices. Reflecting the funds' underperformance in the bull market for bonds, both funds' are allocated only a single star by Standard & Poor's.

"The goal is to give the advisor and their client a way to hedge an existing bond position that already is in their portfolio," says Ruff, who uses a combination of derivative products to structure that hedge. Advisors who use the product, she says, need to be able to use their own models to calculate how much of the Juno fund is needed to hedge each client's position -- and also be prepared to recalculate that position on an ongoing basis as bond prices and yields move.

"You need to understand the models, and it needs to be dynamically managed," she explains. "For those who have the expertise and are willing to spend time on this, it can be a good hedge when rates rise."

But Dimitroff says a downside of funds like Juno and ProFunds Rising Rates Opportunity Fund (which also bets on rising rates) is their relatively high fees. "I just don't have the stomach to pay to 1.4% or more for a bond fund," she says.

Bank loan funds, such as Eaton Vance Floating-Rate High-Income/B (EBFHX), are another alternative. Since the loans it buys are repriced every 50 to 75 days, rising rates have minimal impact on the fund's value, says, Payson Swaffield, co-manager of the bank loan group at Eaton Vance, whose fund is rated four stars by Standard & Poor's. "But as the loan costs rise along with interest rates, the yield goes up," he adds. Of course, there is no free lunch: while there is no interest rate risk, most of the loans are issued by companies whose credit rating falls below investment grade, meaning advisors need to take credit risk into consideration.

If investors are going to take on credit risk, T. Rowe Price's Wiese believes it should be in the shape of high-yield, or junk, bonds. He argues that the best way to brace for higher rates is by structuring a portfolio with short-term bond funds and high-yield funds. "This has the advantage of simplicity -- they're easy for an advisor to explain and a client to understand," he says. The combination of lower-yielding short-term bond funds and junk bond funds, which generate above-average yields and are less correlated to Treasury market moves, offers about the same returns as diversified bond funds, Wiese says, but with less exposure to rising rates. And Wiese, for one, isn't worried about credit risk: "If the economy is indeed strengthening, this may be a good time to be rewarded for taking on that risk," he says.

Wiese is putting his money where his mouth is. "It's an easy strategy to adopt -- and it's the one I'm using in managing my own portfolio," he says.

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