Strategies for the long run

NEW YORK – Bond investors must be feeling pretty grouchy by now.

The Federal Reserve is poised to start raising interest rates at the end of the month. Yields on the 10-year Treasury bond are climbing steadily, and bond prices, which move in the opposite direction, have been falling since March. So far this quarter, fixed income funds are down an average of 2.5 percent, according to industry tracker Lipper Inc.

Despite all this, most financial professionals agree average investors should own bonds, or bond funds – if only for the sake of maintaining a diverse portfolio. Bonds help balance equity risk, and they’re still the best option for long-term investors who are looking for income down the line.

So what can you do to keep the bond portion of your portfolio afloat as rates rise? The steps you take depend on the size of your investment, your time horizon and goals and how much risk you’re willing to take.

“This is a very good time to look at your overall allocation … ask yourself if this is a risk you’re comfortable with,” said Ned Notzon, president of the Spectrum Income Fund at T. Rowe Price, a fund of funds that has shifted its focus to bonds at the shorter end of the yield curve.

“It’s not something you have to do by Tuesday,” Notzon added. “It’s more important that you understand what you’re doing, and not take a knee-jerk reaction and wind up with mediocre investments.”

Longer bonds, which have maturities of up to 29 years, may seem like a good deal at first because they tend to pay higher yields. But when rates are rising, their value can fall. The value of bonds with shorter maturities – two to four years – won’t drop as sharply, but the trade-off is that they pay less.

If you’re invested in a diverse bond fund, chances are the portfolio manager has already sold off longer bonds in favor of those with shorter maturities. But if you hold more specialized bond instruments, you might need to make some adjustments yourself.

Rates are currently at historic lows, so chances are they’ll keep rising over the next two or three years. That means even if you only who reallocate once a year, it’s still a good idea to shorten your bond maturities.

For active traders with larger portfolios, there are other ways to minimize losses during the next phase of the bond market. If you believe inflation will continue to rise, you might consider investing in Treasury Inflation-Protected Securities, or TIPS. Sold in five- and 20-year notes, TIPS are similar to U.S. Treasury bonds, but adjusted to eliminate the effects of inflation.

You could also hedge against interest-rate related losses with reverse bond funds, which are designed to perform in inverse correlation with the market. For example, if the bond market declines 2.5 percent, an inverse fund would go up 2.5 percent. This instrument, like TIPS, is for more sophisticated investors, and should only make up a small percentage of your total portfolio.