The Federal Reserve recently raised its target federal funds rate for
first time since March 2000. This could be just tip of iceberg, though, as many experts believe rising inflation and a strengthening economy will spur continued rate hikes for foreseeable future. This is bad news for bond investors, since bonds lose value as interest rates rise. The reason stems from fact coupon rates for most bonds are fixed when bonds are issued. So, as rates rise and new bonds with higher coupon rates become available, investors are willing to pay less for existing bonds with lower coupon rates.
So what can you do to protect your fixed-income investments as rates rise? Well, here are five ideas to help you, and your portfolio, weather storm.
1.Treasury Inflation Protected Securities (TIPS)
First issued by U.S. Treasury in 1997, TIPS are bonds with a portion of their value pegged to inflation rate. As a result, if inflation rises, so will value of your TIPS. Since interest rates rarely move higher unless accompanied by rising inflation, TIPS can be a good hedge against higher rates. Because Federal government issues TIPS, they carry no default risk and are easy to purchase, either through a broker or directly from government at www.treasurydirect.gov.
TIPS are not for everyone, though. First, while inflation and interest rates often move in tandem, their correlation is not perfect. As a result, it is possible rates could rise even without inflation moving higher. Second, TIPS generally yield less than traditional Treasuries. For example, 10-year Treasury note recently yielded 4.75 percent, while corresponding 10-year TIPS yielded just 2.0 percent. And finally, because principal of TIPS increases with inflation, not coupon payments, you do not get any benefit from inflation component of these bonds until they mature.
If you decide TIPS makes sense for you, try to hold them in a tax-sheltered account like a 401(k) or IRA. While TIPS are not subject to state or local taxes, you are required to pay annual federal taxes not only on interest payments you receive, but also on inflation-based principal gain, even though you receive no benefit from this gain until your bonds mature.
2.Floating rate loan funds
Floating rate loan funds are mutual funds that invest in adjustable-rate commercial loans. These are a bit like adjustable-rate mortgages, but loans are issued to large corporations in need of short-term financing. They are unique in that yields on these loans, also called “senior secured” or “bank” loans, adjust periodically to mirror changes in market interest rates. As rates rise, so do coupon payments on these loans. This helps bond investors in two ways: (1) it provides them more income as rates rise, and (2) it keeps principal value of these loans stable, so they don’t suffer same deterioration that afflicts most bond investments when rates increase.
