Buckle up, bond investors. It's about to get bumpy.
As the Federal Reserve begins tapering its economic stimulus program in the weeks ahead, market strategists widely predict that rock-bottom interest rates, which have fueled a 30-year bond market rally, will trend slowly higher starting later this year.
"I think an interest-rate rise looks pretty inevitable at this point, with tapering now on track," said John Napolitano, a certified financial planner and chief executive officer of U.S. Wealth Management, noting higher rates are good for financial institutions, insurance companies and equity investors alike.
Indeed, the central bank's decision to take the training wheels off the U.S. economy (as underlying performance data permit) is a positive sign overall, indicating the markets are now sturdy enough to stand on their own.
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But it also presents a pickle for fixed-income investors, who will no longer be able to rely on conventional Treasurys and long-term bond funds as a stable income source when rates eventually rise, according to Pam Dumonceau, an independent investment advisor with wealth-management firm Consistent Values.
"Most bond investors right now don't understand the risks they are facing in a rising interest-rate environment," she said.
Interest rates and bond prices generally move in opposite directions—when interest rates rise, bond prices fall, and vice versa.
Nowhere to go but up
Many industry experts insist that interest rates will remain at historical lows despite the government's gradual reduction of quantitative easing—and that may be true for a while.
But the federal funds target rate, which is artificially low due to intervention, currently hovers near 0 percent. Ultimately, it has nowhere to go but up.
"I think everyone agrees that rates will creep up over time," said David Blanchett, a certified financial planner and head of retirement research for mutual-fund tracker Morningstar. "The only question is when and how much."
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As such, bond investors should adjust their allocations now to deflect risk and take advantage of market opportunities, he said, noting long-term bondholders face the greatest risk.
Indeed, some fixed-income securities are more sensitive to interest-rate changes than others.
"I think everyone agrees that rates will creep up over time. The only question is when and how much."
To evaluate your bond portfolio effectively, said Blanchett, you must understand duration.
Duration is a number that indicates how much the price of your bond investment will likely fluctuate when interest rates change.
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The higher a bond's duration, the more rate sensitive it is.
A bond fund with a 10-year duration, for example, will decrease in value by 10 percent if interest rates rise 1 percent (or 20 percent if rates rise 2 percent). Conversely, it will increase by 10 percent if rates fall by 1 percent.
The Financial Industry Regulatory Authority warns that outstanding bonds, particularly those with a low interest rate and high duration, may experience significant price drops as interest rates rise.
That's not to say fixed-income investors should dump their bonds and move to cash, which would guarantee a loss of purchasing power, said Dumonceau at Consistent Values—although she does recommend a six-month to two-year cash cushion so investors don't get stuck selling into a down market.
Instead, yield-hungry investors will need to assume greater risk in their fixed-income portfolios.
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Alternatives to long-term Treasury bonds include convertible corporate bonds, senior floating-rate funds, high-yield bonds issued by companies with lower credit ratings, nonpublicly traded real estate investment trusts and master limited partnerships, according to Dumonceau.
Municipal bonds, which offer tax-free yield, also offer benefits, particularly as investors come to terms with the new Medicare investment-income surtax, she added.
"The situation requires us to take more credit risk in order to mitigate interest-rate risk," Dumonceau said.
Napolitano of U.S. Wealth Management and Morningstar's Blanchett agreed: Long-term bonds are out, and short-term securities are in.
"Keeping maturities shorter than five years will dampen volatility as rates rise," said Napolitano, noting foreign and emerging-market debt may also provide downside protection as domestic rates rise.
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So, too, can dividend-paying equities, but choose wisely. Yield-rich stocks, such as utilities and telecommunications firms, are "a bit overpriced right now," he said.
Going forward, Napolitano added, investors should also be wary of traditional bond funds.
Bucking traditional bond funds
"Bond investors need to be very selective as rates rise," he said, noting many investors have learned the hard way that they can't control the asset mix in a bond fund. "If the manager has a mandate to own only certain types of fixed-income securities, he may not have the ability to move around the sector."
In today's market, Napolitano said, "go anywhere" fixed-income funds are ideal. His top picks: Goldman Sachs Strategic Income Institutional [GSZIX], Templeton Global Bond Fund [TPINX], Oppenheimer SteelPath MLP Alpha A [MLPAX] and JPMorgan Alerian MLP Index ETN [AMJ].
In a rising interest-rate environment, bond investors must be willing to diversify their fixed-income allocations and assume greater risk to meet their income needs.
"People always think about bonds as the safe part of their portfolio, but now we're in a place where bonds could be just as risky as the equity side of your portfolio," Blanchett said.
—By Shelly K.Schwartz, Special to CNBC.com