The Federal Reserve continues to keep interest rates ultra-low to help stimulate the economy. Although a sustained increase in rates may still be a way's off, one is almost certain to occur at some point.
It's a particular concern to investors in bond mutual funds, who face potential losses from rising rates. Losses can occur when a fund generates less interest income, or yield, than going market rates. A fund's returns will vary because the fund manager must continually reinvest as bonds mature. This year's small rise in Treasury yields means previously issued bonds paying lower interest are worth less than they once were. A fund with too much invested in those older bonds can end up with losses. That's because a fund's return is a function of bond price changes as well as the yield, or interest payments, that bonds generate.
One option to reduce risks from a potential rise in rates is to invest in mutual funds with portfolios of bonds that mature, or pay back principal, over relatively short durations. The shorter the average duration of bonds in the portfolio, the less vulnerable it will be to rising rates.
Morningstar bond fund analyst Michelle Canavan identified four bond funds that offer strong potential to avoid losses when rates rise. Each fund has an average portfolio duration that's below the average of peers in the same fund category. Each also possesses strengths that earned the fund either a silver- or bronze medal rating from Morningstar analysts. Those ratings are a subjective system that attempts to gauge a fund's performance prospects, not just its past record. The scale runs from gold to silver, bronze, neutral and negative.
Returns through Jan. 9, 2012