As rates climb, not all bond funds are created equal

By Steve Rothwell
AP Markets Writer

It’s not all doom and gloom for bond investors.

Bondholders have had a rough summer with yields rising as the Federal Reserve considers ending its bond-buying stimulus program. The yield on the 10-year Treasury note is close at its highest level in more than two-years as investors sell bonds in anticipation of less stimulus and, ultimately, higher interest rates.

As rates climb, newer bonds offer higher payments, making older bonds less attractive and pushes down their value. That hurts investors who own previously issued bonds that make lower interest payments.

Although rising interest rates are bad news for bondholders, investors shouldn’t tar all bond funds with the same brush, says Eric Takaha of Franklin Templeton. Takaha is the co-lead manager of the Franklin Strategic Income fund, which invests in a wide range of bonds, and bond-like securities, both in the U.S. and overseas.

Many of these investments, such as high-yield bonds and bank loans are less sensitive to changes in interest rates than government Treasurys are. Instead, they’re more closely linked to how the economy is performing and can do well in a period of rising interest rates.

In fact, only a small part of the Strategic Income fund’s $10.3 billion portfolio is invested in Treasury notes and mortgage-backed bonds. Those are the parts of the market that are typically the most sensitive to a rise in interest rates.

Q: So rising Treasury yields don’t impact all areas of the bond market in the same way?

A: Everyone kind of lumps fixed income all together and says, “Wow, if rates are going up, then there are not that many opportunities.”

But the point is really, on an intermediate-term basis, there are a lot of pockets that have pretty low correlation with U.S. rates. You can still earn some pretty decent income and protect some of the downside in a period of rising rates.

Q: About 30 percent of your portfolio is invested in high-yield securities, what’s your rationale?

A: We are still fairly comfortable with where we are in the corporate credit cycle, in terms of defaults and in terms of ratings. Although you have seen some recent signs that companies are becoming more shareholder friendly in general, we still think that default rates are likely to remain somewhat benign through the end of year and into early 2014.

Traditionally, when you look over the medium term, when you have a period of rising rates, you actually see high yield bonds rally a bit, because the economy is doing OK and corporate earnings are doing OK.

Q: So there are still opportunities in the bond market?

A: The sell-off in high yield over the last few months creates a better buying opportunity. Expectations still need to be moderated because you are not going to see the types of returns that you had a few years ago. But we think relative to other fixed income you can still earn pretty decent interest payments.

Q: What are your thoughts on the municipal bond market following Detroit’s bankruptcy?

A: There have been a lot of negative headlines, and whenever that’s the case that probably creates a good opportunity to look longer term. There are a lot of municipalities, where even though they might generate some negative headlines, they will be fine over the long term. So, you can actually buy bonds now that offer yields that are well in excess of taxable Treasury rates. We think that’s a good situation even though you don’t get the tax benefit if it’s in a fund like this.

A: What are your other big investments?

Q: Most of our holdings right now are in bonds issued in other currencies than the U.S. dollar. It’s not so much an investment based on a government’s creditworthiness but also in the currencies. So when we think about our overseas investments they tend to be in countries that we think will outperform from a growth perspective versus the U.S., the euro region and Japan. And so we’re looking not just to get the additional yield offered in those areas but, also some currency appreciation.

We tend to hold fairly short positions. So if you look at our investments in Asian countries, or in Sweden or Poland, they tend to be in very short maturities. Are larger positions are in South Korea, Malaysia, Sweden and Poland.