Faced with rising interest rates and falling bond prices, plenty of investors are racing to protect portfolios. Some advisors are adding short-term bonds. Those can be relatively resilient, but short-term securities can still suffer red ink when rates climb. For better results, consider stock and bond investments that thrive when rates rise. By adding a small dose of such diversifiers, advisors can cushion portfolios and possibly boost long-term returns.

 

Merger Funds

Institutions and wealthy individuals have long prized merger arbitrage hedge funds because they churn out single-digit results almost every year. As interest rates climb, the funds tend to deliver higher returns. Top choices for mutual fund investors include Merger Fund (MERFX) and Arbitrage Fund (ARGAX). The funds proved their value during the last big rate rise, which occurred in the three years that began in 2004. During that time, the Federal Reserve raised the federal funds rate from 1 percent to 5.25 percent. For the period, Merger Fund returned 5 percent annually, topping the average intermediate government fund by a wide margin, according to Morningstar.

Merger funds typically invest in shares of companies that are about to be acquired. Say an acquirer announces that it will buy a company for $10 a share. Before the deal closes, the shares may trade for $9.50 because investors worry that the acquisition could collapse and the shares would decline. The merger funds buy the discounted shares, betting that the deal will close and produce a small profit. As interest rates rise, profits from individual deals tend to climb. This occurs because merger investors seek to earn about 4 percentage points more than Treasury bills. If Treasury bills yield 1 percent, then investors want to earn at least an annual rate of 5 percent on a deal. The investors want to receive 6 percent when T-bills yield 2 percent. If the potential profit is too low, then deal investors will sit on the sidelines until the share price sinks. “We want to be paid for the risk that we take,” says John Orrico, portfolio manager of Arbitrage Fund.

 

Bank and Insurance Stocks

During the 12 months ending Sept. 6, financial funds returned 26.4 percent, compared to 18.2 percent for the S&P 500. Rising interest rates are providing a special boost to insurance companies. Insurers typically collect claims and invest the cash in bonds. Higher bond yields translate into more profits. “When interest rates move up, insurers can get higher returns on equity without doing anything,” says John Fox, portfolio manager of FAM Value (FAMV), a mutual fund that has one-third of its assets in financial stocks.

When rates rise, banks can charge borrowers higher interest rates. That can fatten bottom lines. Wider spreads are particularly important for community and regional banks. While money center institutions can derive revenues from investment banking and other activities, regional banks focus on making loans to consumers and small businesses. For a solid mutual fund that specializes in small banks, consider Hennessy Small Cap Financial (HSFNX), which returned 30.4 percent in the past year.

 

Bank Loan Funds

These invest in adjustable-rate loans that banks make to companies with below-investment-grade credit. When rates rise, borrowers must pay more. That boosts loan prices at times when Treasury bonds are falling. During most years, the funds produce solid single-digit returns. The exceptions occur when loan prices fall because investors worry about defaults. But such weak periods tend to be short and prices recover quickly. With investors worried that the European crisis could sink global markets, loan prices softened in 2011. For the year, bank loan funds returned 1.6 percent. In 2012, prices rebounded, and the funds returned 9.4 percent.  

This year, the improving economy has helped loan funds stay on track. While intermediate-term bond funds lost 2.3 percent in the first six months of 2013, bank loan funds gained 2.5 percent. The strong performance did not go unnoticed. During the first seven months of the year, investors poured $38 billion into bank loan funds and withdrew $31 billion from intermediate funds. The flood of cash has pushed up prices of loans, which will limit future returns. But the loans still yield about 4 percent and the funds are on track to deliver decent single-digit returns in the coming year. 

A mutual fund with a steady record is Eaton Vance Floating Rate (EVBLX). During the past five years, the fund returned 5.3 percent annually. To avoid trouble, Eaton Vance focuses on higher quality investments and underweights loans with grades of CCC, the lowest ranking. “If you buy CCCs, you are left with a volatile return profile,” says Christopher Remington, an institutional portfolio manager for Eaton Vance.

 

Stable Value Funds

These account for about 20 percent of the assets in 401(k) plans. As interest rates rose this year, millions of plan participants had little reason for concern. Account balances in stable value funds climbed steadily. Because of the reliability, account holders tend to think of the stable funds as bank certificates of deposit—investments that cannot lose money. But the funds are not backed by FDIC insurance. Most of the stable funds invest in portfolios of bonds. To protect shareholders, the portfolio managers purchase coverage from insurance companies. The approach has succeeded admirably. The funds have never recorded a losing year, and the results have about matched the returns of mutual funds that invest in a mix of short and intermediate bonds. The funds currently yield 2 percent, and that will rise as interest rates climb.

If stable funds did run into problems during a bond bear market, then the insurance providers would have to step forward to make sure that no account holder suffered a loss on a withdrawal. The insurance companies say that they are equipped to avoid losses if rates keep rising. “Rates have risen a number of times in the past 35 years, and stable value funds have always performed as expected,” says Aruna Hobbs, managing director of New York Life, which manages stable value funds.