January 17, 2005  Email this  Print this
 License or reprint this articleKEEPING YOUR BALANCE
Six Income Havens as Rates Rise
by Jeffrey R. Kosnett  Last year's interest-rate alarm was false, but we're confident we'll see the real deal in 2005. The questions are how fast and how high, which means if you're an income investor, you need to prepare. Some bonds and bond alternatives are perfectly sound when interest rates are moving up gradually. Others are to be avoided. The good news, however, is that with the enormous range of ways to invest for income, you don't have to toss everything into a money-market fund or a bank account or risk getting hammered. As long as long-term interest rates don't rise dramatically, things like mortgage-backed securities, intermediate-term corporate and Treasury bonds, high-yield "junk" bonds and most municipals will hold their value or lose only a few scraps of principal. In addition, if you have maturing CDs or money in the bank, you'll be able to invest it or reinvest it now at better yields.
What I'm saying is that the prospect of moderately higher rates isn't such a bad thing. And I'm not just saying that to go with the flow.
Six safe havens
Ted Wiese, a bond manager for T. Rowe Price, looked back recently at other periods of rising rates and found quite a few good interest-paying ideas. In no particular order, he likes:
- high-yield
- mortgage-backed securities
- non-dollar-denominated debt
- TIPS, Treasury inflation-protected securities
I'll add a couple of my own ideas: floating rate bank-loan funds and stable value accounts. T. Rowe Price doesn't have the first kind of fund, so I'll bet that's why my pal Wiese skipped over it. Fair enough. A few thoughts on each:
High-yield. It's not cheap like it was two years ago, when the rates were so much higher than Treasury bonds that the risk was negligible. But as long as the economy hangs in there, the idea that these bonds' prices are due to crash is silly. I would expect them to move in close lockstep with long-term Treasury bond prices for a while-a small erosion of principal, maybe a percentage point or two-but offset by the income.
Good no-load junk funds are yielding 7%. So maybe you'll make 5% total in 2005. Decent.
Mortgages. The thinking here is that if rates go up, the biggest problem in owning Ginnie Maes or funds of them disappears: constant refinancing. Repeated refinancings return your principal month after month and eat into your yield. I know: I bought a $25,000 Ginnie Mae bond for my IRA years ago at 8.5%. I have about $500 of it left. All the rest got called in when the mortgages were refinanced. But there's less chance of that now.
You can buy GNMA securities to yield around 6%, or if you prefer, a fund like Vanguard's GNMA (VFIIX) yields 4.3% and insulates you from the prepayments because it keeps the duration very short. You won't lose any money by year's end.
Overseas bonds. Here, there is risk, but a global or international fund gives you the opportunity to profit from diversification and from investing in a basket of currencies. Don't look for any more giant gains in the value of, say, Brazilian or Canadian debt as those countries' currencies strengthen versus the U.S. dollar, but sound foreign bonds should hold their current values and pay decent interest. Unfortunately, sales loads and high expenses plagued many of the funds in this realm, but a few stand out. Northern Global Fixed Income (NOIFXR), which is big on Japanese and European issues and avoids "emerging" nations, has expenses of little over 1% and a yield of nearly 5%. It's a good one.
I'll skip TIPS, since I'm not sure if there will be inflation enough to make them pay.
My final ideas are floating-rate funds and stable value accounts. The first is a fund whose price is supposed to increase as rates rise because it invests in pools of bank loans. As the variable rate the banks charge increases, the fund's return goes up, too. Some skeptics say they aren't tested enough, but so far Fidelity's Floating Rate High Income Fund (FFRHX) has passed along fair income with hardly any change in net asset value.
Lastly, if your 401k or other retirement fund has a stable-value option, check to see if it's a true institutional-type stable value account, one that holds pieces of loans and other private placements and uses insurance to keep the principal value steady. If so, it probably yields at least 3% now and that will rise as new money comes into the bank or the insurance company and they lend it at higher rates. One of the good things about a time of rising short rates and flattish long rates is the safest stuff pays you better and the riskier things don't feel the pain.
So don't get weak-kneed about bonds and other income investments in 2005. It'll be better than you think.
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