Let’s consider what drove investors to move about $500 billion into long-term bond funds holding U.S. Treasurys and investment-grade bond funds in the first place. Many of them had been holding money-market funds and wanted higher yields; they chose high-quality bond funds to minimize their exposure to risk.
And they did minimize their exposure to credit risk: Treasury bonds won’t default, nor will most investment-grade bonds. Yet they unwittingly took on a huge amount of interest-rate risk — when interest rates rise, prices of high-quality bonds fall.
In October, the interest rate on 10-year U.S. Treasurys was 2.3 percent. By February, it had climbed to 3.6 percent, though it has recently fallen back a little. That 1.3-percentage-point increase in the interest rate on 10-year Treasury bonds translates into a 5.6 percent decrease in their price — a disaster for investors who thought they were opting for safety.
The worst may be yet to come. Interest rates on 10-year Treasurys have a long way to rise before they reach historical averages. Over the past half-century, the median rate for 10-year Treasurys has been about 5 percent.
So how can bond investors obtain higher yields than money-market funds without taking on so much interest-rate risk? One possibility is to buy high-quality bond funds with very short maturities — in the range of one to two years. Although such short-term funds will have lower yields than long-term Treasury funds, they will also have much less exposure to sharp rises in interest rates.
A second option is to buy funds that invest in high-yield bonds, commonly called junk bonds. Such bond funds have higher yields than Treasury bond funds and much lower interest rate risk. But junk bond funds do involve a significant amount of credit risk — some of the bonds they hold will default. It’s important to choose a junk bond fund that reduces credit risk by holding a well-diversified portfolio and avoiding the lowest-rated bonds.
Look overseas
Funds that invest primarily in emerging-market bonds are another option. Like junk bond funds, emerging-market bond funds have higher yields than Treasury bond funds — and less exposure to interest-rate risk. But again, emerging-market bond funds entail a great deal of credit risk. The key is to find a diversified fund that invests primarily in the emerging markets that have risen to investment grade, such as Brazil and Taiwan.
A final idea is to invest in funds that primarily hold TIPs — Treasury Inflation-Protected Securities. Such Treasury bonds have minimal credit risk and pay a relatively low base rate of interest, plus additional interest based on the rise in U.S. consumer prices. If interest rates rise sharply, consumer prices will generally follow, so investors would receive an additional interest payment on TIPs.
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