Fixed-Income Favorites for Rising Rates

11/14/2016 10:00 am EST

Focus: FUNDS

With year-end rate hike odds estimated at better than 50/50, fixed-income investors are understandably skittish. These funds will help you prepare for higher rates, suggests Tim Begany, editor of Investing Daily's Personal Finance.

Vanguard Short-Term Investment Grade (VFSTX) is an excellent place to park money while rates rise. It has a 2% yield and a long history of minimizing interest-rate sensitivity.

hat 2% yield is markedly higher than the 1.5% peer-group average.

Launched three decades ago, Vanguard Short-Term Investment Grade is an excellent—and safe—place to be when rates rise.

VFSTX holds up well in rising-rate environments mainly because it has a low “duration,” a rate-sensitivity measure defined as the number of years it takes to collect all bond interest and principal.

Its five- and 10-year annualized returns—2.5% and 3.4%, respectively — beat eight out of 10 peers. If the Federal Reserve hikes rates a quarter point in December as expected, VFSTX share price would likely fall a mere 0.65%.

Long-time lead manager Gregory Nassour is no fan of credit risk. His fund averages an A rating which, along with a short duration, limits price fluctuation. The past five years, VFSTX was nearly 90% less volatile than the S&P 500.

PowerShares Senior Loan Portfolio (BKLN) currently yields 4.3%. The five-year-old fund is a $5.7 billion ETF index fund of higher-yielding corporate bonds known as senior loans.

Senior loans are also referred to as leveraged loans or bank loans. They yield more because they involve more credit risk, usually in the B to BB range.

But the price of senior loans don’t get hit nearly as hard as traditional fixed-coupon bonds when rates rise. This is because senior loan coupons reset frequently, typically every 30 to 90 days.

This results in short durations, the time it takes to collect all bond interest and principal. As such, senior loans show little interest rate sensitivity.

The portfolio’s 0.32 duration indicates extremely low interest rate sensitivity. If rates went up 1%, BKLN would only be expected to drop about 0.3%, versus roughly a 6% loss for a fund tracking the broader bond market.

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