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What's happening in bonds? A second year of rates grinding higher signals a key turning point.
"The days of earning 7% total returns as yields fall are over," says Bob Persons, co-manager of the MFS Bond Fund. "We're now looking at an environment where you should expect 2% to 4%."
That's not a call to bail out of bonds. "Remember, the reason you own bonds is to control the overall risk of your portfolio," advises Wayne Schmidt, chief investment officer at Gradient Investments.
Treasuries, the ultimate safe haven, are also the most sensitive to rising rates. Long-term ones took a serious hit during the four-month rate spike in 2013. And a total bond index mutual fund or an exchange-traded fund, which tends to act like an intermediate-term fund, is bulked up on Treasuries today.
The Barclays U.S. Aggregate index , the benchmark for most diversified bond funds, has more than one-third in Treasuries, compared with 20% a decade ago.
So to temper your rate risk and earn more than the 2% your core bond fund is paying, peel off a small portion -- say 20% or so -- and redirect it to other pockets of the bond world, starting with the ideas below.
1. Aim for the sweet spot with corporates
With yields on five- to 10-year corporate bonds up far more than short-term rates, you're being rewarded more than you were a year ago for tiptoeing into longer maturities. And as long as you're patient, you can withstand rate hikes.
Stick to corporate funds with durations of five years or so (duration indicates what percentage a fund's price will fall per a one-point hike in rates). And to wring out more income without undue risk, sacrifice a little on quality with BBB-rated bonds, the lowest rung of investment grade. "Companies are reporting record free cash flows, and the economy is growing," says Persons. "There's no need to be so defensive."
How to invest: The USAA Intermediate Term Bond Fund (3.6% yield) has 48% of the fund in BBB and single-A issues, 25% higher than the category norm.
2. Municipal bonds are today's best value
Muni bonds typically pay less than comparable Treasuries. Yet today high quality munis yield at least as much, even before the tax break. The reasons: investor jitters in the wake of Detroit's bankruptcy and concerns over Puerto Rico's financial stability. (Many muni funds own Puerto Rican debt because interest is tax-free in all 50 states; the typical muni fund, though, has less than 5% of assets in Puerto Rico bonds, reports Morningstar.)
Still, fewer than 1% of all muni bonds are in bankruptcy. "The vast majority of the market is fundamentally sound," says Mark Paris, a municipal bond manager at Invesco, "and with the economy improving, municipalities are seeing their revenue improve as well."
These days Marilyn Cohen, whose Envision Capital Management specializes in fixed-income investing, favors revenue bonds, whose payments rely on a steady stream of income from essential public services like water and electricity. General obligation bonds, on the other hand, are backed by a municipality's ability to raise taxes, which is often politically unpopular.
How to invest: Vanguard Intermediate Term Tax-Exempt , a Money 50 fund (recent yield 3.2%), has just 28% in G.O. bonds and an average duration of 5.5 years. The iShares National AMT Free Muni ETF (2.9%) keeps more than two-thirds of the portfolio in revenue bonds; its average duration is seven years.
3. With high yield, look for quality
If you've been enjoying high payouts from junk bonds of late, you've no doubt noticed that yields have fallen from above 8% two years ago to under 6% today; income seekers have been flocking into the market, pushing prices higher and yields lower. Plus, a record amount of ultra-low-rated corporate bonds were issued last year, amping up the risk in this already dicey sector.
Since you're not getting paid nearly as much as you once were to take on the stocklike price swings of junk, Wells Fargo's Jacobsen recommends tilting toward the highest-rated portion of high yield: "crème de la junk" rated BB, where you can still get a 4.5% to 5% yield without taking on the risks of the lowest-quality issues. In the 2008-09 selloff, bonds rated BB lost 16%, while CCC and lower-rated bonds lost 41%.
How to invest: The Power Shares Fundamental High Yield Corporate Bond ETF (4.6% yield) focuses on quality junk; currently more than two-thirds of the bonds in the portfolio are rated BB or higher, and the fund owns no bonds rated below B.
4. Embrace a new way to avoid price swings
You can boost your income by shifting money into corporates, munis, or high-yield bond funds, but you are putting your principal at risk -- you could take a loss if you have to sell when rates are on the rise and prices are down. With individual bonds, on the other hand, if you hold on until maturity, you know exactly how much you'll get back. The downside is that it's costly to put together a diverse portfolio.
A new breed of ETFs gives you the "best of both worlds," says Gradient Investments' Schmidt. With defined-maturity ETFs from Guggenheim and iShares -- portfolios of corporate and municipal bonds that all mature in the same year—you get diversification and the knowledge of how much you'll get back and when.
How to invest: Both firms offer maturities ranging from one to seven years, so you can lock in short and intermediate rates. "lt's a cost-effective way to own a portfolio of bonds but also control your interest rate risk," says Schmidt.
How to build a ladder
With $10,000, you can create a high-quality corporate bond ladder with Guggenheim Bulletshares defined-maturity ETFs.
Yield on each $2,000 investment by maturity date:
Effective yield: 2.1%
SOURCES: Morningstar, Money research