The retiree game plan to counter rising interest rates

We have been talking about interest rates with our clients for years now, as historically low rates have retirees—and those who rely on income from their portfolios—yearning for yield.

So the expectation of higher interest rates is, for many investors like our clients, not a bad thing, since rising interest rates will mean their long wait for higher yields is coming to an end. But traveling into higher-interest-rate territory can be treacherous and calls for some careful planning.

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Generally, the worst place to be when rates are rising is in bond funds or bonds with long maturities and low coupons, since they will suffer the most as interest rates rise. Years' worth of gains could be wiped out if rates jump quickly.

We have been focused on this risk now for some time and have migrated our portfolios away from longer maturity, lower-yielding securities (investment grade). The general changes we've made include shortening the maturities of our core bond exposures while taking advantage of the higher yields available from the highest-quality corporate junk bonds.

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But there are different strategies that investors need to know about beyond the barbell investment approach that many of them takemeaning that they own bonds and cash on one end and stocks on the other. These strategies have the potential of providing risk and reward greater than bonds but less than stocks. I like to call them "the stuff in between."

Here are two of our "stuff in between" strategies that we believe will hold up well in a rising-interest-rate environment.

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Long-short bond funds

Long-short bond funds look to invest in bonds and other fixed-income investments while hedging against rising interest rates. We currently use two funds to accomplish this: Driehaus Active Income and Driehaus Select Credit.

For the past several years—since the Federal Reserve all but flattened interest rates—retirees have had to make some tough choices: Invest in longer-term bonds with a higher yield but with more interest-rate risk, or in lower-quality, or junk, bonds with a higher yield but more credit risk.

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One example of a long-short bond strategy that Driehaus employs is buying longer-term corporate bonds to take advantage of the higher yields, then taking a portion of the portfolio and shorting Treasurys to hedge against rising interest rates. If and when interest rates increase, their short Treasury positions will add some protection against falling bond prices.

Over time, we hope to see this investment achieve half of the return of stocks with 33 percent of its volatilityvery similar to what we expected from bonds a decade or two ago.

Short-term high-yield bonds

Lower-quality companies issue bonds, also known as high-yield or junk bonds, that offer higher yields for investors who are willing to take more risk. But the risk experienced with these types of bonds can often be similar to that of stocks. Basic high-yield or junk bonds may be just too volatile for many seeking yield.

However, by shortening the duration of a higher-yielding corporate bond portfolio, risk is lowered to a more acceptable level for our clients.

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We like the Osterweis Strategic Income Fund because it invests in short-term high-yield bonds with an average duration of two years. By investing in those bonds with short maturities, we reduce volatility but still enjoy a better yield than we would get from bonds issued by higher-quality companies.

We hope to achieve a 4 percent to 6 percent total annual return with 50 percent of the risk of high-yield bonds and 33 percent of the risk of stocks with this strategy.

"Having a balanced approach to fixed-income investing, while including 'the stuff in between,' may give retirees the best shot to achieve attractive yields and return with potentially less volatility."

Interest rates are hard to predict. Even as many economists were expecting rates to rise, the 10-Year Treasury fell to 2.65 percent by the end of the first quarter of this year, down from 3.04 percent at the end of 2013.

I've been known to say, "When everyone in the market expects one thing, the opposite often happens."

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That's why we believe having a balanced approach to fixed-income investing, while including "the stuff in between," may give retirees the best shot to achieve attractive yields and return with potentially less volatility. At least, until the return of the 5 percent certificate of deposit.