In-Flux Interest Rate Draws Attention to Bonds

With interest rates potentially continuing to rise, bond markets may receive renewed attention from mutual fund investors, according to the Associated Press.

"Right now, investors should be thinking about diversified asset allocation," said Margo Cook, who oversees Bank of New York's $6 billion institutional fixed income division.

Although rock-bottom interest rates have driven investors away from bonds and toward higher-performing equities, Cook and others advise investors to avoid portfolios that are saturated with stocks, regardless of future changes to the interest rate.

"If an investor is quite aggressively in equities right now, I think it is reasonable to diversify given the fact short funds give a nice yield," said Todd Barre, vice president and senior strategist for Harris Private Bank.

And if history is any indication, short and intermediate-term bonds might be the best bet.

When interest rates are lowest, long-term bonds typically offer the best performance, but they can also lock-up investors' cash for up to 30 years and fluctuate with the interest rate. 

On the other hand, short-term bonds, which mature in less than two years, and intermediate bonds, which, at most, take a decade, are most active immediately after interest rates stabilize.

When the Federal Reserve Bank raised rates seven times between 1994 and 1995, ratcheting up interest rates from 3% to 6%, intermediate bonds shot up 17.8%. Between 1999 and 2000, the rate rose six more times, from 4.75% to 6.5%, and intermediate bonds went up 9.7%, according to fund watcher Morningstar.

Since Jan 1., intermediate bonds have risen 1.8% in anticipation of the Fed finishing hikes.

Lipper Senior Analyst Andrew Clark predicts respectable returns for intermediate bond funds in 2006, noting that half of  the Denver-based research firm's model portfolio is invested in corporate bonds. Half of those bonds are triple-B-rated, and half are high-yield.

Clark said although intermediate bonds are his first pick, long-term bonds still offer great potential. "Once the Fed starts slowing, this will be the next place investors look to," Clark said.