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What to do with your bond portfolio as Fed rates rise

The Federal Reserve raised interest rates Wednesday, and that will affect your bond holdings.

Though a quarter point increase to the Fed's benchmark rate will not drastically change your returns, a prolonged campaign of rate hikes may be a short-term drag on your fixed income investments, as rising rates mean lower bond prices.

"If you own individual bonds outright, they will continue to pay the stated coupon rate, and mature at par value regardless of price changes," said Amy Hubble, a certified financial planner and principal at Radix Financial in Oklahoma City, Oklahoma. "While it can be frustrating to see losses in traditionally safe investments, it also means fixed income investors will finally be able to reinvest at higher, positive real rates of return."

If you haven't reviewed at your bond portfolio in awhile, here's what you should know:

Know your appetite for risk

Investors always talk a big game until they start taking losses. It's only natural. In general, we feel loss more than gains. It's a trait behavioral economists call "loss aversion."

If the prospect of seeing the fixed income part of your portfolio in the red, consider keeping a little more cash on the sidelines. It can act as a "shock absorber" against the losses, said David Demming, a CFP in Aurora, Ohio.

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"We have not had a sustained rising rate environment since the 1970s," Demming said. "Fortunately, we have had practice with such events." He is holding short-duration bonds in his clients' portfolios as interest rates rise, which are less sensitive to rate hikes.

Duration is the measure of interest rate sensitivity, expressed in years. For example, Vanguard Total Bond Market Index, the largest U.S. bond fund by assets, has an average duration of 6 years. That means that, if rates were to rise by 1 percentage point, this fund could lose as much as 6 percent.

Stay diversified

If you like your portfolio's risk level, you should keep it. The important thing is to maintain a diversified portfolio because holding different kinds of stocks and bonds will usually perform better with less volatility over time than one concentrated in a few investments.

"We feel that a portfolio's asset allocation should diversify fixed income assets just as it would equity investments across different asset classes," said Adam Reinert, a CFP with Marshall Financial Group in Doylestown, Pennsylvania. "In fixed income, this includes diversifying interest rate, credit and purchasing power risks."

For example, one type of fixed income asset Reinert recommends in this market is floating-rate loans, which are notes that adjust their coupon payments as rates rise and fall. "However, there is no free lunch," he said. "An important trade-off is while these investments can protect from interest rate risk, they do at the expensive of credit risk," meaning returns could be more volatile than a plain-vanilla bond fund.

Focus on fees

If rising rates mean lower bond prices, the fees charged by your bond funds become more important.

The average intermediate-term bond fund, which typically buys and sells bonds with durations of 3 years to 10 years, charges 0.79 percent annually, according to investment research firm Morningstar. Index funds that track a market benchmark levy fees that are much lower. For instance, the Vanguard Total Bond Market Index fund has an annual fee of 0.16 percent.

The lack of transparency in the bond markets should give active fund managers an edge compared to index funds that track a benchmark. However, only 39 percent of active intermediate-bond fund managers beat their benchmarks over a 10-year period through June 30, a Morningstar analysis found.

You can improve your odds of success by investing in a fund that charges a lower annual fee. For example, 47.3 percent of active managers of intermediate-bond funds that were in the lowest fee quartile of their peers beat their benchmarks. Not as good as a coin flip, but better than the average.

Ultimately, however you choose to invest, rising rates is good for investors and the economy.

"I have had a number of clients asking about the possible rate hike," said Mark Rylance, a CFP and co-owner of RS Crum in Newport Beach, California. "I tell them that increasing interest rates is the best thing that could happen to them.

"Not only does it show that the economy is gaining strength, but it also gives them an opportunity to lock in higher rates at some point in the future," he added. "I think it is a misconception to be afraid of higher interest rates — unless you are a net debtor instead of a net saver."

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