Retirement Q&A: Investing strategy as rates rise

Q. What are the riskiest investments to hold in a period of rising interest rates, and what are the best places?

A. To some extent, that depends on what interest rates you expect to rise. The traditional advice for income investors is to avoid long-term bonds, because those bonds get hurt worse than short-term bonds when rates rise.

To measure interest-rate exposure, money managers use a figure called duration. A fund with a duration of 10 years, for example, will see its share price fall 10% for every percentage-point rise in interest rates. A fund with a three-year duration would see its share price fall 3% for every percentage-point rise in duration.

If only life were so simple. The biggest problem with duration is that not all rates rise and fall at the same time. The Federal Reserve, for example, largely controls short-term interest rates, and if the economy starts to pick up, it's short-term bonds that will get whacked the most, says Ken Volpert, head of Vanguard's taxable bond division.

That's unfortunate, because investors are rushing into short-term bonds, Volpert says. "It's unbelievable how much is pouring into the short end of the bond market," he says. Should short-term interest rates rise by a percentage point, taking down a two-year Treasury note by 3%, they won't have much interest income to offset that loss. The two-year T-note yields 0.31%.

At the same time, Volpert thinks that intermediate-term bonds are reasonably priced at the moment. "We think the 10-year is a good place to be," he says. While 10-year Treasuries yield just 2.75%, the FlNRA/Bloomberg Active U.S. Corporate Bond Index, which measures high-quality corporate bonds, yields 3.68%.

Another area Volpert likes: municipal bonds. Munis have gotten so clobbered by the woes of Detroit and Puerto Rico that bonds issued by highly stable municipalities offer real value. Currently, for example, a 10-year muni bond yields 2.67%, nearly the same as a 10-year T-note. But a muni is free from federal i! ncome taxes (and state taxes, too, if it's from the state where you live).

Have a retirement question? Send it to jwaggoner@usatoday.com for consideration in a future column.

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