Where to go as interest rates rise

Rising interest rates can be a good thing. They may mean better returns from bank savings accounts and money-market mutual funds. They also may be a sign of an improving economy because demand for credit increases.

But the past few months of rising interest rates have also meant falling bond prices and lower returns from bond mutual funds. So far this year, the average intermediate-term bond fund has lost approximately 2.3 percent, according to Morningstar Inc. in Chicago.

Few bond funds can escape the impact of rising interest rates, so investors need to make a choice. They can withdraw all their money from bonds and put it in, say, a money market fund (where it won't earn much interest, but won't lose money either). Or they can reposition their bond holdings to ride out the storm.

Many investment advisers suggest the latter strategy, keeping some money in bond funds because, over time, their returns from income and price appreciation will easily beat money market funds.

The trick, they add, is to find those funds that can weather the storm better than others.

For some investors, the answer will be municipal bond funds. With income that's free of federal income tax - as well as state tax for funds that buy bonds from an investor's own state - municipal bond funds have long been attractive to investors in high tax brackets. Also, prices of municipal bonds may not fall as much as Treasury bonds, which are traded more frequently.

"Municipal bond prices on the whole tend to track Treasuries pretty closely," says Martin Vostry, a research analyst at Lipper. "But they also tend to be a little less volatile. So if prices of Treasuries fall 5 percent, munis will fall, too, but not as much."

Investors who can stand a little more risk might consider high-yield municipal funds for a small part of their bond portfolio, says Stephen Overstreet, a financial planner in Winter Springs, Fla. These funds invest in bonds issued by state and local governments that have relatively low credit ratings. So far this year, the total returns of these funds have been comparable to those of many general bond funds, but they also offer the potential for higher income.

"I can use them for a short period of time," Mr. Overstreet says. "And I use them for a small amount of money."

Overstreet recommends bond investors also consider taxable high-yield bonds and put them in IRAs or 401(k) accounts where any income and appreciation are tax-deferred.

In fact, Lipper's Mr. Vostry notes, municipal bonds funds held outside IRAs or similar accounts may not be completely tax-free. While the income is not taxed, any profits, or capital gains, earned by the fund when the managers sell bonds at a profit are taxable. "The fund may have a 10 percent return and 5 percent is capital gain," he says.

Also, experts say, investors need to be aware of the alternative minimum tax, or AMT. This separate tax system, created in 1969 to ensure that even the wealthiest taxpayers pay their fair share of federal income tax, now hits an increasing number of households with modest income. That's because it failed to take into account the impact of inflation.

As a result, some previously tax-free income, such as from municipal bonds, may be taxed at 26 or 28 percent, leaving investors with less yield than Treasuries but with more risk.

One way to keep a bond portfolio from getting hammered when interest rates rise, experts say, is to invest in short-term bond funds. These funds will lose value in a rising-rate environment, but probably not as much as longer-term funds.

This principle applies to municipal, government, and corporate bonds. While longer-term funds have higher yields than funds with shorter-term securities, the higher yield may not be enough to justify the risk of price fluctuation when rates rise.

"Any time interest rates rise, the longer maturity bond is going to lose value," says Michael Tankersley, a financial planner in Birmingham, Ala. "The strategy I've been using is to go into lower maturities."

"In general, to protect against rising interest rates, you'll want a shorter duration," agrees Scott Berry, a senior analyst at Morningstar.

Among municipal bond funds, he says, the Vanguard Short-Term Tax-Exempt Fund and the Vanguard Limited-Term Tax-Exempt Fund have both weathered previous downdrafts in the bond market relatively well. For example, he recalls, the average municipal bond fund lost 6.7 percent in 1994 and 4.8 percent in 1999. Both Vanguard funds, however, "squeezed out small gains in '94 and '99, so they are going to be less interest-rate sensitive than most," he believes.

To see how vulnerable a fund might be to rising interest rates, investors can check the average maturity of the portfolio. In general, a shorter average maturity means less risk.

For example, at the end of May, the average maturity of the Vanguard Limited-Term Tax-Exempt Fund was 2.9 years, while the Short-Term Fund's average maturity was 1.3 years. By comparison, the Vanguard Intermediate-Term Tax-Exempt Fund's average maturity was 5.6 years.

In spite of rising interest rates, municipal bond funds are benefiting from the improving national economy, which has sent more tax dollars into states' coffers.

"States seem to be getting their financial houses in order," Mr. Berry says. "These improvements should provide some cushion against rising rates, but I still expect some [price] volatility."