When interest rates increase, bond prices tend to decrease. The magnitude of this interest rate sensitivity is measured through duration, explains Todd Rosenbluth, S&P Capital IQ Director of Mutual Fund Research in S&P Marketscope.
A bond mutual fund with an average duration of two-and-a-half years should expect a 250 basis point decline in value if rates increase 100 basis points, while a bond mutual fund with an average duration of five years should expect a 500 basis point decline.
So investors seeking to protect against potentially higher rates in 2015 should consider short-term funds.
We contend that when choosing a short-investment-grade bond fund, which typically has duration below two-and-a-half years, investors should consider a number of factors.
We highlight two funds that have relatively strong risk-adjusted track records, above-average 30-day SEC yields, and below-average expense ratios.
These and other factors are part of the S&P Capital IQ mutual fund ranking on approximately 3,500 taxable bond mutual fund share classes.
4-star rated Lord Abbett Short Duration Income Fund (LALDX) rose 3.6% in the three-year period ended December 5, ahead of the 1.7% peer average. While its standard deviation is slightly higher, its Sharpe ratio of 2.5 is much stronger (1.1 for its peers).
The fund sports a 2.5% 30-day SEC yield, (0.90% peer average), due in part to 20% exposure to speculative-grade bonds that incur above-average credit risk. Further helping its ranking is a modest 0.58% expense ratio, below its 0.82% average.
5-star rated Vanguard Short-Term Investment Grade Fund (VFSTX) climbed 2.5% in the three-year period and has an above-average Sharpe ratio of 1.8.
The fund's 30-day SEC yield of 1.4% is also higher than its peers, but lower than LALDX as it has just 2% in speculative-grade bonds. The Vanguard fund has a significantly lower than average 0.20% expense ratio.
Both funds have exposure to domestic and international corporate bonds, though LALDX has a larger position in US mortgage bonds than VFSTX. We believe these are two strong funds for investors to consider if they believe interest rates will move higher in 2015.
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