4 fixed-income strategies for a rising-rate environment

State revenues have risen for 14 straight quarters, which may bode well for the municipal bond market

By Scott E. Couto

Apr 30, 2014 @ 8:50 am EST

As the bull market celebrates its 5th birthday, the party favors you may be wishing for most — other than predictability over the next five years — are answers. Among the questions on the minds of investors:

• "What should I consider if interest rates rise?"

• "Are there still growth opportunities in equities?"

• "How can volatility create investment opportunities?"

So what should investments should be on your radar to produce income, as interest rates rise and bonds lose their luster? While the prevailing wisdom is that when interest rates rise, you should move out of bonds, the truth is that doing so may not be a wise move. Diversification is always important. In a rising-interest-rate environment, you may want to consider — or talk to your investment adviser about — a broad range of fixed-income classes:

1. Anchor your portfolio with high-quality bonds

Rather than abandoning bonds in favor of stocks, investors can focus on the role bonds play in a diversified portfolio — income, total return potential and an offset to equity volatility. Anchoring your portfolio with high-quality bonds may be an appropriate strategy. Historically, high-quality bonds have performed well when stocks have declined and typically have provided steady income.

2. Explore non-core-income options

In a low-yield environment, building a portfolio with the potential to generate income may mean exploring non-core-income options. For investors who can tolerate more risk, adding non-core-income assets may offer higher income potential as well as diversification benefits such as lower sensitivity to rising rates. Some of these fixed-income investments include: high yield, which can be less sensitive, floating rate, which can move with rates, emerging markets, which can provide diversification, or real estate, which offers lower correlation.

3. Use short-term bonds to help lessen interest rate sensitivity

Diversifying with short-term bond funds may help reduce the impact of rising rates. In general, bonds with shorter durations typically experience smaller price changes when interest rates move, compared to longer-duration bonds.

4. Add municipal bonds

Sixty-five percent of the time, municipal bonds outperformed taxable bonds over the past 20 years when adjusted for a 25% tax rate. Municipal bond funds historically have provided attractive benefits — tax-free federal income that can add total return and attractive diversification benefits due to their low correlation to stocks and other fixed-income investments. Moreover, state revenues have risen for 14 straight quarters, which may bode well for the municipal bond market. Investing in high-quality municipal bonds may reduce credit risk and volatility. Extensive credit research is instrumental in identifying financially sound issuers and potentially avoiding defaults.

One of the most critical take-aways in this interest rate environment is to always keep risk in mind. In chasing yield, many investors lose sight of the risk side of the equation. They may have exposed their portfolios to risks more closely correlated to equities. Now more than ever, it is important for investors to know what they own in their bond portfolios.

Scott E. Couto is president of Fidelity Financial Advisor Solutions.

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