Do not make this mistake with your bond investments

The following was written by Yahoo Finance Contributor Kathryn Cicoletti and appeared here on her Tumblr page

There seems to be some confusion surrounding how to “play” your bond portfolio in a rising interest rate environment. Let’s take a step back for a moment. Where are these conversations stemming from?

There have been two key large moves in interest rates recently. Since mid-April, the yield on the 10-year Treasury note (TNX) climbed from 1.8% to 2.1% and the yield on the 10-year German bund climbed from 0.06% to 0.44% over a similar timeframe. Remember that if you own a 10-year Treasury bond, its value decreases when interest rates increase because you’re now holding an older bond that pays a lower interest rate than the current yield.

Then there’s the “smart money” institutional investors who have been all over the news talking about how they are going to navigate their funds in a rising rate environment. Bill Gross of Janus Capital recently fired off a tweet about how the German bund is the “short of a lifetime.” Shortly after, Norway’s $900 billion sovereign wealth fund announced they are rejiggering their bond portfolio to shorter maturities.

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Rising interest rates and widely covered commentary by institutional investors surrounding this topic is enough to send individual investors into a state of panic regarding their bond fund exposure.

But here’s the thing. With regard to how to “play” a rising interest rate environment in your bond portfolio, shorting bonds (like the German bund) vs. just investing in short duration bonds are two completely different strategies when attempting to protect your bond portfolio from rising interest rates. One has a much higher risk profile and one as a lower risk profile, but they’re both in the same conversation about “how to play” a rising rate environment without noting that they are actually quite different.

Let’s start with the more risky one. Bill Gross manages a $1.5 billion bond fund at Janus Capital (JNS). The fund is an “unconstrained” bond fund (JUCDX). The key difference between a traditional bond fund and an unconstrained bond fund is unconstrained bond funds have a high amount of flexibility with regard to the types of bond strategies they can implement. One of them being they are allowed to short bonds. Unconstrained bond funds are very hedge-fund like in this regard. Since they’re allowed to short bonds, they have the potential to make money when interest rates are increasing.

Contrast that with investing in “short duration” bonds or bond funds. Duration just means sensitivity to moves in interest rates. Shorter duration means the value of those bonds are less sensitive to an increase in interest rates than bonds with longer duration, like the 30-year Treasury bond.

This is what Norway’s sovereign wealth fund is doing to address rising interest rates. The government is weighing their $328 billion bond portfolio to shorter maturities. This is still a traditional (long) bond strategy and is very different than what unconstrained bond funds can do (“short” bonds). It is also a much less risky strategy. Like any long-short investing, there is limited downside with buying the investment (going long) but there can be unlimited downside associated with shorting the investment (going short).

Janus is pushing their unconstrained bond fund hard. This is only the beginning of the slew of funds that you’ll see as a potential way to “play” a rising interest rate environment. There is a big difference between an unconstrained bond fund that can “short” bonds, and investing in “short” duration bonds. The former is a potential way to make money in a rising interest rate environment, but also carries a lot more risk. The latter is way way to “lose less” in a rising interest rate environment, but carries less risk.

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