Now that the Federal Reserve has announced it might wind down its stimulus program, it's critical to adjust your portfolio.
Bond prices fell as yields rose to a near two-year high last week. The Treasury sell-off was sparked by Fed Chairman Ben Bernanke's comments the central bank might begin scaling back purchases of Treasury and mortgage securities later this year.
The impact of rising interest rates, which depress bond prices, are measured directly through duration. Duration measures a bond portfolio's sensitivity to rates. For each percentage point uptick in rates, the duration gauge shows you how much money you can lose in principal. Generally, the longer the duration, the greater the chance you'll lose money.
Say you have an investment-grade bond with a duration of 14.5 years that carries a 4.5 percent coupon and matures in 30 years. If rates tick up 2 percentage points, you could lose 26 percent of the bond's market value. Every bond portfolio prospectus or website should give you duration measures.
They can also be found on any financial portal online.
Of course, this is an extreme example, but you need to be careful to ensure your portfolio is insulated from interest-rate risk, which is highest for long-maturity bonds.
"What really concerns us is an over-allocation to long dated bonds," said Dan Keady, a certified financial planner and director of financial planning for Manhattan-based TIAA-CREF, the financial services company. "How are you going to offset duration risk?" Shortening bond maturities to single digits is one defensive approach. Buying funds that invest in bank loans is another.
Unlike conventional bond portfolios, bank-loan funds purchase floating-rate notes that can track rising rates. They've been extremely popular this year as rates inched up and investors have pulled money out of conventional income funds.
Relative to intermediate or long-maturity bond funds, bank-loan durations are minuscule, typically under a year, so they have some of the lowest rate-risk profiles. While yields also are small, that is the trade-off for using this kind of fund.
More than $24 billion has flowed into bank-loan funds this year through May, according to Morningstar Inc., leading the top bond categories with a 30 percent growth rate. That compares with an outflow of more than $10 billion for intermediate government bond funds.
It's not too late to make adjustments if you hold long-maturity bonds, since the Fed is not expected to begin curtailing its easing program until later this year.
While there are more than 40 mutual funds that invest in floating-rate loans, they generally have high expenses of around 1 percent annually, which is lofty for a bond fund. Bank loans are best held through exchange-traded fund portfolios, which have much lower costs.