Smart Strategies for an Overheated Bond Market

Bond prices are way up, and yields are way down. If interest rates spike in this environment, many long-term bond investors may get burned. These investment ideas can help you find higher yields, while taming the risk of rising rates.

Bond prices are way up, and yields way down. But we’re not in a bond bubble yet, says Paul Jacobs, CFP, client service manager with Palisades Hudson Financial Group’s Atlanta office. Unlike technology stocks, or Dutch tulips, the downside with bonds is limited by one’s ability to hold them to maturity.

That would be cold comfort, however, if you invest in long-term bond mutual funds — when interest rates eventually go up, your investment sinks. “A sharp hike in rates could send long-term bonds down 20 percent or more,” Jacobs says. And unlike individual bonds, bond funds never mature, he says.

Given the low yields and risks in the fixed-income market, what should an individual investor do? Jacobs suggests these steps:

Invest in high-quality short-term bond funds. By short-term, Jacobs means really short-term — bond funds with durations of about one year.

“While yields are modest, volatility with short-term bonds is very low, and a spike in rates would not have a dramatic impact on performance,” he says.

Among taxable funds available to the public, Jacobs likes the Goldman Sachs Enhanced Income Fund (GEIAX), which invests in a mixture of corporate and U.S. agency bonds. Its expense ratio is low, and that’s important -- with today’s low rates, high-expenses would eat up a lot of yield.

In the municipal-bond arena, Jacobs invests in the Vanguard Short-Term Tax-Exempt Fund (VWSTX), which boasts a penny-pinching 0.20% management fee.

In the 2008 stock-market crisis, when many bond funds tanked, both of these funds came through fine, he says.

Add yield with a floating-rate fund. Floating-rate bond funds, or so-called bank-loan funds, invest in floating-rate loans. The bonds are attractive because the debt is senior in the company's capital structure, meaning they’re first in line to get repaid in the event of a bankruptcy filing.

Because interest rates on the underlying loans go up when rates go up, “you win instead of lose if that happens,” Jacobs says. Floating-rate loans pay higher yields, but have low-credit quality, so limit them to 10% to 15% of your bond portfolio, he advises.

Jacobs favors the Fidelity Floating Rate High Income Fund (FFRHX) because he believes it is the most conservative floating-rate fund. Annual expenses are 0.74%, almost half a percent lower than the average floating-rate fund.

Invest in TIPS directly. Unlike most other bonds, U.S. Treasury Inflation-Protected Securities (TIPS) appreciate in value when inflation goes up. “Buy individual TIPS. It’s not worth paying a mutual fund company to manage them for you because other than maturity date, all TIPS share the same characteristics,” he says.

You can purchase TIPs directly from the government at the Treasury Direct website.

If you’re still not convinced that the bond market is overbought, consider this. More money flowed into domestic bond funds in 2009 alone than in the previous 10 years combined, Jacobs points out. June 2010 marked the 30th consecutive month that more money flowed into bond funds than stock funds.

Palisades Hudson Financial Group is a fee-only financial planning firm headquartered in Scarsdale, N.Y. It offers estate planning, insurance consulting, trust planning, cross-border planning, business valuation and appraisal, family office and business management, and executive financial planning. Its sister firm, Palisades Hudson Asset Management, is an independent investment advisor with $1 billion under management. Branch offices are in Atlanta and Ft. Lauderdale, Fla.