Steps to Safety
1. Check default risk.
In a U.S.- government bond fund, you don't have to worry. For a corporate bond fund, review the prospectus. You want an "investment grade" fund, which means the fund buys bonds of companies with the highest credit ratings.
2. Find out interest-rate risk.
The key factor is your fund's "average duration," which you'll find in the prospectus. The longer a fund's duration, the more you'll lose when rates rise. A bond fund that has "long-term" in its name is usually much riskier than a "short-term" fund. But don't rely solely on the name.
To find out what a rate increase might cost you, multiply your fund's average duration by the hypothetical rate increase. Let's say your fund has a three-year average duration. If interest rates were to rise 2 percentage points, you could expect a 6 percent drop in market value. The same rate increase might erase 20 percent from a bond fund with a ten-year average duration.
3. Consider your timeline.
If you won't be tapping a short- or intermediate-term bond fund for at least ten years, you have less to fear from interest-rate risk. As rates rise, your reinvested dividends will buy new, higher-yielding bonds; over time, the income from these can offset the short-term drop in the fund's value.
4. Reallocate your money.
If your bond choices seem risky based on what you've learned, transfer your dollars to safer choices. Again, look at the fund's prospectus. Three good categories to consider:
A short-term bond fund
Opt for atop-quality fund that has an average duration of under three years and buys only government bonds or investment-grade corporate bonds. To maximize your return, pick a fund with very low expenses. A few examples: Vanguard Short-Term Bond Index Fund; T. Rowe Price Short-Term Bond Fund; JPMorgan Short Duration Bond Select; and USAA Short-Term Bond Fund. (Beware of "ultrashort" bond funds, which often boost yields by buying inherently riskier low-quality bonds. In 2008 ultrashort funds that held subprime-mortgage instruments had devastating losses.)
A ladder of CDs
Certificates of deposit are very low-risk bond investments. With a ladder, you divide your money equally between, say, five CDs of different maturities ranging from one to five years. You'll earn more than you would if you put all your money into a one-year CD. And every year a CD that's maturing will give you cash to reinvest as interest rates rise.
A stable-value fund
If you participate in an employer-sponsored retirement plan such as a 401(k), you may have this option. Stable-value funds invest in government bonds and high-quality corporate bonds, and they have insurance to protect your principal against interest-rate risk. Investors have rarely lost money in such funds, but be forewarned: their insurance generally doesn't cover losses caused by an employer action that prompts workers to cash out in droves, such as a mass layoff or a bankruptcy. When Chrysler was on the verge of bankruptcy in 2008, for example, so many employees cashed out of a stable-value fund set up for its white-collar workers that it had to be liquidated, paying only 89 cents on the dollar.
5. Don't panic.
It still makes sense to invest in bonds. You just need to remember that your primary goal as a bond investor should be safety, not a high return.
Contributing editor Lynn Brenner reported on new rules for Roth IRAs in the March–April issue.