How to play rising bond rates without losing your shirt in principal 


If rates keep rising, that tension will only grow. The prevailing market wisdom — at least before the recent volatility in stocks and increasing concerns about a slowdown in the U.S. economy — had been that the Fed would hike as many as three times next year. The Fed is expected to raise rates again this month after its two-day meeting on Dec. 18-Dec. 19, with the market placing the odds of the increase at 78 percent as of last Friday. Many economists still expect three hikes next year as well.

But the interest rate situation is fluid. The weaker than expected nonfarm payroll number last Friday was read by some market experts as a sign that the Fed would be more patient with rate increases. Some also interpreted a recent speech by Fed chairman Jerome Powell as a sign that the Fed might slow down the pace of rate hikes — he said rates “remain just below the broad range of estimates of the level that would be neutral for the economy.”

Powell is not the only Fed official who has recently been preaching patience.

Predicting the direction in interest rates is a tough business, and one basic fact won’t change: Bonds traditionally are safer than stocks, while delivering lower returns. Chip Norton, managing director of Naples, Florida-based fixed-income asset manager Wasmer, Schroeder & Co., which manages roughly $9 billion for its clients, says nothing that pays a high yield is totally safe, and nothing that’s totally safe pays a high yield. So bond strategists such as Norton say the trick for income investors when rates rise is to contain principal losses on bonds to bolster total returns.

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The simplest way to control bond principal risk is simply to hold bonds to maturity. If a small investor is satisfied with the 3 percent interest that 10-year Treasurys are paying, and buys some, that income is fixed for the term of the bond. Since Treasurys, rated Aaa by Moody’s Investor Service, are the closest thing to a bond with no risk of default, an investor who buys them at par value will get 100 percent of principal back when the bond matures, along with all the interest paid in between.

Fluctuations in the value of that bond as rates rise and fall have no impact on investors who hold the Treasurys but don’t trade them, says Stephen Laipply, head of fixed-income strategy for the iShares ETF business at asset management giant BlackRock.

“If you hold the bond and there’s no credit event [like a default], you’ll collect at par,” Laipply said. “If you hold to maturity, you will be fine.”



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