investing

A Bond Strategy to Protect Your Savings

Worried about inflation? Shorten your maturities.

OUR READERWho: Gary Radford, 73Where: Fayetteville, N.Y.

Question: With rising rates ahead, How can I keep my money safe in a portfolio of bond funds?

Gary, a retired banker, has invested in bonds for 20 years through funds -- such as his favorite, Pimco Total Return (symbol PTTAX) -- and privately managed bond accounts. He's been satisfied with his returns, but now he senses it's time to think harder about his plan because rising interest rates are on the horizon. "I don't want to tread water," he says. "But I certainly don't want to take any losses."

Gary has a pension, and he and his wife both draw Social Security, so he says he isn't dependent on bond income. His priority is keeping his savings secure. One option would be to lighten up on bonds and transfer some of the money to a savings account or certificates of deposit.

Gary has good reason to be wary of rising rates. As the economy improves, or as financial markets fret about inflation, rates generally rise. And as interest rates rise, bond prices fall. So even if a bond fund has great management, there's limited wiggle room to avoid losses. "A bond fund is a bond fund," says Krishna Memani, director of fixed income for Oppenheimer Funds. "If rates go up, there are relatively few levers to reduce risk."

So Gary can't expect a fund manager to switch strategies to protect his money (and neither should you). But Gary could shorten the duration of his bond funds. "Duration is, in essence, the exposure of your bond fund to a one-percentage-point move in interest rates," explains Marc Labadie, director of investments for RTD Financial Advisors, in Philadelphia.

For example, a fund with a duration of five years would lose 5% if interest rates on the fund's holdings rise by one point. If rates rise one percentage point in each of the next three years, you could face three years of negative total returns. But a fund with a short duration, say one year or less, won't get burned. (Bond funds generally list duration on their Web sites, along with yield and expenses.)

So if Gary were to switch, say, half of his stake in Pimco Total Return, which has a duration of 4.8, to a fund such as Pimco Short-Term (PSHAX), with a duration of 0.5, he'd cut his risk roughly in half, says Labadie.

Deborah Frazier, founder of Frazier Financial Consultants, in Chapel Hill, N.C., has already advised her clients to sell half of their Pimco Total Return holdings. She recommends Vanguard Short-Term Investment-Grade (VFSTX), a member of the Kiplinger 25, which yields 0.9% and has a duration of 2.2.

Other Considerations

Another point to keep in mind is how your funds are diversified across types of bonds. Gary and everyone else should have a mix of corporate and short- or intermediate-term government issues.

Perhaps the best idea -- although it's not Gary's choice and it isn't for everyone -- would be to forgo funds and build a laddered bond portfolio. This means buying individual bonds with staggered maturity dates, which guarantees that you will get back your principal as long as the issuer doesn't default. "No matter how much volatility there is, as long as you're buying high-quality debt, you're not worried about price fluctuations because you're holding until maturity," says Labadie.

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