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Bonds: How to Play Interest Rate Peril

By David Bogoslaw

Interest rates can turn quickly, as the Greek government learned when its 10-year bond soared more than 9 percentage points in the past year on default worries. Such danger has some fixed-income investors considering a new approach: mutual funds that hold a variety of bonds, including U.S. Treasuries, corporates, mortgage-backed securities, municipals, and senior bank loans. Especially attractive now are multisector funds touting a more active approach to portfolio management, with the flexibility to drift from benchmark allocations to respond to changing market conditions.

Fund tracker Morningstar (MORN) estimates that 22 so-called unconstrained bond funds currently manage a total of $53 billion in assets. That's roughly a quarter of 87 multisector bond funds Morningstar has identified with assets under management totaling around $169 billion. The new breed of fund accounts for just a meager fraction of the $2 trillion held by 1,127 taxable bond funds. Fund flows for 12 of the 22 unconstrained funds have generally trended higher since January, with five funds showing big spikes in April or May as the debate around the U.S. debt ceiling heated up. The strategies of these "go-anywhere" funds aren't uniform. Some focus on reducing their portfolio's average duration (the percentage by which a bond's value is likely to drop for every 1 percent rise in interest rates), while others concentrate on getting the highest yield for the least amount of credit risk.

"Multisector funds have been most popular because people are thinking, 'Is there a bond bubble?'" says Philip Condon, head of municipal bonds at DWS Investments in New York. "Investors recognize that Treasuries probably aren't the best value when you see yields" below 3 percent. "Multisector bond funds are offering the ability to find that value in the marketplace."

The nimbleness of these actively managed funds comes at a price. In place of interest rate risk, they often expose investors to elevated credit risk or, in the case of certain emerging market debt, liquidity risk. And some of these funds charge fees roughly twice as high as funds focused on a specific part of the fixed-income market, although high-yield and short-duration funds also tend to have higher fees. "In general, it's a pretty untested group," says Miriam Sjoblom, a bond fund analyst at Morningstar. "We don't have a long track record of seeing how these funds hold up in different environments."

When interest rates rise, bond yields move higher, pushing prices of existing bonds lower and causing investors to lose principal on the bonds in their portfolios. The best protection from this, many believe, is to lower the duration of the bonds they hold, which limits the loss of principal and allows fund managers to buy higher-yielding bonds sooner once interest rates begin to climb. A bond's duration measures how sensitive its price is to a change in interest rates and is calculated by taking the final maturity and yield into consideration.

Rick Rieder, BlackRock's (BLK) chief investment officer for actively managed fixed income and manager of the firm's Strategic Income Opportunities Fund (BASIX), is less concerned now about being burned by rising interest rates than he was six months ago, when the U.S. economy seemed to be on a more certain growth track. In late 2010 and early 2011, Rieder says he had a larger exposure to "risk assets," such as high-yield corporate bonds.

"We still have exposures to high yield and commercial mortgages but have reduced those exposures significantly over the last two months, mostly in anticipation of the end of quantitative easing 2 and increased volatility around that," he says. "The summer is a tougher liquidity period generally, and QE2 provided a tremendous foundation of liquidity because of what the Fed was putting into the system."

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Hoenig Urges Fed to Raise Interest Rates to Encourage Saving

May 29, 2011, 12:22 AM EDT By Eric Martin

May 29 (Bloomberg) -- Federal Reserve Bank of Kansas City President Thomas Hoenig, the central bank’s longest-serving policy maker, said the U.S. needs to raise interest rates to encourage individuals to save and avoid future asset bubbles.

Hoenig, who doesn’t vote on monetary policy this year, has repeatedly urged the central bank to tighten lending to prevent inflation and asset price bubbles. He voted eight times in 2010 against record monetary stimulus led by Chairman Ben S. Bernanke, tying former Governor Henry Wallich’s record in 1980 for most dissents in a single year.

The Fed cut its benchmark rate to zero to 0.25 percent in 2008 to boost economic growth and will keep it unchanged until the first quarter of 2012, according to the median estimate in a Bloomberg survey of economists and analysts.

“I’m not advocating for tight monetary policy, but I do think we have to get off of zero if we want to avoid repeating some of the mistakes of the past with a very easy credit environment,” Hoenig said in an interview on CNN’s “Fareed Zakaria GPS” show scheduled for broadcast today.

Fed officials are discussing how quickly to begin tightening policy after completing the purchase of $600 billion in U.S. Treasuries by the end of June. They are also considering a strategy for how to remove stimulus, with a majority favoring ending the policy of reinvesting proceeds from maturing securities first before raising interest rates or selling assets, minutes of their April 26-27 meeting showed.

Spending Encouraged

Leaving the Fed funds target at its current level encourages consumers to spend at a time when the U.S. needs higher savings rates to ensure long-term prosperity, Hoenig said in the CNN interview.

The savings rate held at 4.9 percent in April, the Commerce Department said, the lowest level since October 2008.

The Fed under Chairman Alan Greenspan kept interest rates at 2 percent or less from December 2001 to December 2004. The savings rate averaged about 3.4 percent during that period, compared with 5.4 percent in the previous two decades, and fell to 0.8 percent in 2005, the lowest level since at least 1959, according to Commerce Department data. Defaults on home loans to the riskiest borrowers in 2007 and 2008 triggered the worst recession and financial crisis since the 1930s.

“We kept the interest rates too low,” Hoenig, who served on the Federal Open Market Committee that sets interest rates, said of those years in the CNN interview. “It’s not that I want to point blame to myself or anyone else, but I do have to say this is what happened, what were the consequences and what have I learned from it and -- and adjust policy the next time going forward.”

Bernanke, speaking on April 27 at a press conference, signaled that the central bank will maintain its record monetary stimulus after June and indicated that the need to contain inflation means further easing is unlikely.

Hoenig plans to retire from the central bank in October after 20 years as leader of the Kansas City district bank.

“If we want to be a great nation, continue to be a great nation, then we do have to address our fiscal challenges,” Hoenig said in the CNN interview, according to an advance transcript of his remarks.

--With assistance from Steve Matthews in Atlanta. Editors: Ann Hughey, Kevin Costelloe.

To contact the reporters on this story: Eric Martin in Washington at emartin21@bloomberg.net

To contact the editor responsible for this story: Mark Silva at msilva34@bloomberg.net

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