Rate-Defying Tricks

With the economy improving and interest rates still near four-decade lows, bond investors might be feeling afraid, very afraid. And with good reason a sharp rise in rates would punish most fixed-income holdings. Government bonds, which enjoyed a ferocious rally in recent years, pose particular risks. To appreciate the dangers, recall the experience of 1999, the last time rates climbed sharply. During

With the economy improving and interest rates still near four-decade lows, bond investors might be feeling afraid, very afraid.

And with good reason — a sharp rise in rates would punish most fixed-income holdings. Government bonds, which enjoyed a ferocious rally in recent years, pose particular risks.

To appreciate the dangers, recall the experience of 1999, the last time rates climbed sharply. During that year, yields on 10-year Treasuries climbed from 4.69 percent at the beginning of January to 6.45 percent at the end of December. Responding to rising rates, long-term government funds lost 8.2 percent for the year, while intermediate municipal funds dropped 2.5 percent, according to Morningstar, the Chicago-based fund tracker.

But not all yield instruments gushed red ink during the bond collapse. An odd collection of vehicles actually made money — or at least avoided losses. For example, bank loan funds returned 6.1 percent in 1999, while high-yield bond funds produced 4.5 percent. Other survivors included convertibles and multi-sector bond funds. Though these investments come with different risks, they all seem likely choices to thrive under current conditions. “Now is the time to diversify a fixed-income portfolio by adding bank loans or other instruments that can do well when rates rise,” says Jeffrey Margolin, an analyst for Ryan Beck & Co.

Bank On It

Bank loan funds are particularly compelling because their returns often rise when investment-grade bonds fall. The funds invest in adjustable bank loans where the yields go up and down along with interest rates. If rates rise by half a percentage point, then the yield of the bank fund will climb by about that amount. The funds currently yield 3.7 percent, 3 percentage points more than money market funds.

“Bank loan funds are ideal choices for conservative investors who can't stand the low yields on money markets and are worried about interest rate risk,” says Paul Dunbar, a partner with TOS Advisors, a registered investment advisor in Bloomfield Hills, Mich.

Make no mistake, bank loan funds come with risks. Funds invest in loans made to companies considered below investment grade. Inevitably, a few of the investments disappoint. During the downturn of 2001 and 2002, defaults spiked, and prices of loans slipped. Since then, defaults have dropped sharply, and prices have recovered. The revival helps explain why bank loan funds have returned 10.8 percent in the past year. Can the funds deliver double-digit results in 2004? Probably not, says Payson Swaffield, a manager of Eaton Vance Prime Rate Reserves, a bank fund that has never posted a losing year. “You will collect decent yields,” he says. “But loans are fairly priced now, so you can't expect to see much capital appreciation this year.”

Those willing to tolerate more risk can invest in high yield funds, which own bonds rated below investment grade. Even though they are not adjustable, junk bonds often rise during periods of climbing rates. In a typical scenario, the economy improves and rates rise. Under such conditions, junk bond prices tend to climb as defaults decline and investors bid up junk prices. With defaults dropping sharply, junk bonds have enjoyed a nice run in recent months. Still, the average high-yield fund yields 7.1 percent, and if the economy continues expanding, the funds could record a bit of capital appreciation on top of their yields. A solid choice is Evergreen High-Yield Bond, which holds a diversified collection of bonds in chemicals and energy that should benefit from an improving economy.

Tops Down

Convertibles offer another way to perhaps record some capital gains while obtaining income. If interest rates rise this year, convertibles could still deliver equity-like returns. “Convertibles usually do well when the economy is coming out of a recession,” says John Valentine, president of Valentine Retirement Planning Group, a registered investment advisor in San Ramon, Calif.

The typical convertible is a bond that can be converted to a fixed amount of equity — provided the common stock climbs to a certain level. Because of the potential for conversion to equity, convertible prices tend to rise during periods when common stocks are climbing. While waiting for the convertible and the common to climb, investors receive a consolation prize in the form of a bond-like yield; the average convertible fund currently yields 3 percent.

Hybrid creatures that they are, convertibles have a mix of traits, sometimes resembling bonds and on other occasions acting more like stocks. During the bull market of the late 1990s, aggressive convertible funds with equity-like technology holdings brought the biggest rewards. But the fun ended with the market crash, and more moderate choices held up best. For steady results, consider Victory Convertible, which holds a mix of different kinds of convertibles and focuses on investment-grade names. “Sticking with the higher-quality convertibles helps keeps us out of trouble,” says Rich Janus, a portfolio manager.

One way to own convertibles is with Pioneer High Yield A, which returned 27.1 percent in 1999. Portfolio manager Margaret Patel looks for convertibles and high yield bonds selling for discounts of 10 percent or more to their initial values. Such downtrodden issues can soar when their prospects improve. That helps to explain how Pioneer High Yield ranks as a top-returning fund, producing 15.9 percent annually for the past five years.

For one-stop shopping consider a multisector bond fund. These typically hold a mix of U.S. governments, foreign issues and high yield bonds. The idea is to provide instant diversification, since the segments don't necessarily track each other. An intriguing choice is Fidelity Strategic Income. Fidelity's foreign bonds could do particularly well this year if the dollar continues falling, boosting the value of overseas issues for U.S. investors. Another multisector investment is Eaton Vance Limited Duration, a closed end fund that holds a mix of bank loans, high yield issues and quality mortgage-backed securities. The fund currently yields 8.7 percent. In a period of rising rates, the mortgages would tank, but the other two categories could compensate for the capital losses, holding their values and delivering rich yields. If Treasury yields rose by one percentage point, the fund could finish the year with a total return of 6 percent or so, estimates Payson Swaffield of Eaton Vance. That would be a winning performance in a difficult period for bond holders.

Funds That Can Rise When Treasurys Sink

Fund Ticker Category One-Year Return Three-Year Return Five-Year Return Max. Front-End Load Expense Ratio
Eaton Vance
Prime Rate
EVPRX Bank loan 7.30% 3.20% 4% 0.00% 1.26%
Evergreen
High Yield A
EKHAX High yield 18.9 10.3 5.6 4.75 1.11
Fidelity
Strategic Income
FSICX Multisector 18.5 11.8 8.4 0 0.84
Pioneer
High Yield A
TAHYX High yield 28.6 13.6 15.9 4.5 1.1
Victory
Convertible A
SBFCX Convertible 14.1 2.6 5.8 2 1.32
Source: Morningstar. Returns through 11/30/03.
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