What to do if interest rates rise

As the 10-year Treasury yield percolates up toward 4% in the latest sign of looming inflation and rising interest rates, investors should start to consider hedging some of their fixed-income exposure.

There is a lot to hedge.

Last year, net inflows to bond mutual funds totaled more than $228 billion, according to Morningstar Inc.

At the same time, domestic equity funds had net outflows of $75 billion.

Risk aversion among investors was even more pronounced in 2009, when bond funds had $363 billion in net inflows and domestic equity funds had net outflows of $24 billion.

“The overreaction to the stock market losses of 2008 has left a lot of investors now overweighted in long-only fixed income,” said Nadia Papagiannis, an alternative-investments strategist at Morningstar.

Although a reversal of the 30-year trend of falling interest rates has been a long time coming — and it is still not clear if we are at the turning point — it is clear that the only likely direction for interest rates is up.

With that in mind, investors would be well-advised to consider ways to reduce the risk in a traditional fixed-income allocation.

One strategy employed by the $2.5 billion Driehaus Active Income Fund (LCMAX) is to invest both long and short in corporate bonds.

The fund, managed by K.C. Nelson at Driehaus Capital Management LLC, was launched in 2005, but the strategy was revised in January 2009 to be duration-neutral and generate alpha by making credit bets.

Last year, the fund gained 5.2%, compared with a 6.5% gain by the Barclays Capital U.S. Aggregate Bond Index and a 7.9% gain by the Bank of America/Merrill Lynch U.S. Treasury 10-year Index.

In 2009, the fund gained 22.1%, while the Barclays Aggregate index gained 5.9% and the 10-year Treasury index lost 9.7%.

The key, according to Ms. Papagiannis, is to achieve returns that aren’t correlated to long-only fixed income.

Along those lines, she is optimistic about a strategy that uses Treasury futures to go long or short and adjusts the duration of Treasury bonds, based on a quantitative outlook for interest rates.

If the outlook is for higher interest rates in the month ahead, for example, the directional bet will be to short the 10-year Treasury.

This strategy is relatively new for mutual funds but has been used by hedge funds for quite some time.

In July, Rydex SGI started offering the strategy in a mutual fund, the Rydex/SGI Long Short Interest Rate Strategy Fund Ticker:(RYBSX).

Another option is the American Independence Absolute Return Bull Bear Fund Ticker:(AABBX), which was launched in August by American Independence Financial Services LLC. The fund applies the same long-short interest rate strategy by investing in exchange-traded funds.

The only other mutual fund that is employing this strategy is the Bandon Isolated Alpha Fixed Income Fund Ticker:(BANAX), which Bandon Capital Management LLC launched in December.

What is unique about the Bandon fund is that half the portfolio is dedicated to taking long and short directional bets on Treasury bonds. The other half tries to isolate alpha using a strategy similar to that of the Driehaus fund.

“The directional bets are not correlated to anything, and it’s a pretty unique strategy,” Ms. Papagiannis said. “This is something hedge funds have been doing for nearly a decade.”

A fixed-income hedge with a longer history among mutual funds involves floating-rate corporate bank loans. Unlike fixed-rate bonds, particularly longer-term bonds, where net asset values typically decline in a rising-rate environment, floating-rate corporate loans are pegged to the London interbank offered rate, and their prices can benefit as rates rise.

In November, ING Investment Management, which manages $9 billion in bank loan portfolios, packaged the strategy in a mutual fund, the ING Floating Rate Fund (IFRAX).

Of course, while the strategy looks solid for a rising-rate cycle, the category was hit hard by liquidity issues in 2008, making the approach appear to be overly correlated to equities during the extreme market downturn.

According to Morningstar, the average bank loan fund fell by 29.7% in 2008 and then bounced back 41.8% in 2009.

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].