With interest rates likely to rise, should I sell my bond funds?

QUESTION: I own the following bond funds: Vanguard GNMA (VFIIX), Vanguard Inflation-Protected Securities (VIPSX) and the Vanguard Total Bond Index Market Fund (VBMFX). I keep reading that because interest rates are expected to go up, bonds aren't the place to be. Does this mean I should sell my funds (which have done really well for me) or just hold on to them? I won't need the money for at least five years.

-- Anonymous

ANSWER: You're right about one thing: With the Federal Reserve indicating that it might hike the federal-funds target rate soon, bonds and bond funds have suddenly become as appealing as a fur jumpsuit on a hot summer night. But that's not to say the prospect of rising interest rates should scare you completely out of bonds, particularly since your investment horizon is five years or longer.

"Investors are just going to have to fasten their seatbelts and recognize that if they've got money in bonds as part of a long-term investment, then they should keep their money in bonds as part of the asset allocation for their overall portfolio," says Lynn Russell, a fund analyst at Morningstar. In other words, bonds are widely considered to be a crucial component of most portfolios.

Now, does that mean you should sit and do nothing while your funds suffer? Certainly not. You may want to shift your bond holdings a bit to protect yourself in this environment. We'll give you some specific advice on how do to that later. First, bear with us while we review some bond basics.

Most folks have heard that when interest rates rise, bond prices fall. Just how much a bond fund will fall in a rising interest-rate environment is best measured by its duration, which gauges the fund's sensitivity to interest-rate fluctuations by taking into account both its maturity and the amount of its coupon payment, explains Harold Evensky, a certified financial planner (CFP) with Evensky Brown & Katz in Coral Gables, Fla. Evensky offers a general rule of thumb: If a fund's average duration is four years, its value will fall about 4% for every one percentage-point hike in interest rates (say, the fed-funds rate). A fund with a 10-year duration, by contrast, will fall 10% for each 1% hike, and so on.

Given that, an investor who follows the economy closely might decide to liquidate all bond holdings as it becomes clear that interest rates are rising. That could be a mistake. The fact is, no one knows the future direction of interest rates. Way back in 2001, pundits were urging homeowners to refinance their mortgages while they still had a chance; surely 7% mortgage rates wouldn't be offered for long, they said. In a way, they were right: Soon after that, rates plunged to 6%, and then 5%.

Remember: The bond market at any given time represents the collective wisdom of thousands upon thousands of professional traders, most of whom live and breathe economic statistics. You can't outsmart them. Heck, even the Nobel laureates who ran the Long-Term Capital Management hedge fund got it flat wrong and almost caused a global economic meltdown back in 1998. So while it might appear right now that rates are headed inexorably upward, there's certainly no guarantee that'll happen. Any number of events could prompt traders to flock to bonds again during the next five years.

That's why it's important to keep all the bases covered with a sound asset-allocation strategy. Even though Evensky says a bond fund with a four-year duration will lose 4% for every one-percentage-point rise in rates, he still recommends that investors have an average duration exposure of around three to four years right now.

His advice for someone in your situation: Reshuffle your bond portfolio so that half of it is invested in a fund with a short-term duration (just one to three years), a quarter in a limited-term duration (which means a duration of three to five years) fund and the remaining quarter in a fund with an intermediate duration (five to 10 years). The three funds you own have intermediate-term durations (according to the Vanguard Web site), so if those are the only holdings in your bond portfolio you might want to consider shifting some assets to shorter-term funds.

Of course, if the impetus for your investments in bond funds is principal protection rather than asset allocation, then you might consider taking your money off the table right now. After all, it does appear that interest rates are headed upward. The yield on the 10-year Treasury has jumped more than a full percentage point in just the last month or so. If you're frightfully concerned about losing principal, Morningstar's Russell recommends a money-market account. But be warned: Interest rates would have to rise substantially in order for money-market funds to offer attractive yields.

All that being said, different types of bonds will react differently to rising rates. Here's a breakdown of how the three funds you own now might perform.

The Vanguard GNMA (VFIIX)
This is a straightforward, plain-vanilla mortgage fund, says Russell. It invests at least 80% of its assets in Government National Mortgage Association (GNMA, or "Ginnie Mae") certificates, which means the fund is backed by the government and therefore has very high credit quality. In general, mortgage-backed securities are less sensitive to interest-rate changes than traditional bonds, partly because of the way mortgages work. As people pay down their mortgage, they pay both principal and interest so money comes back into the fund quicker than with a traditional bond, where principal gets paid back at maturity, explains Michael Boone, a CFP and president of MWBoone & Associates in Bellevue, Wash.

However, there are other factors to take into account when assessing the risk of mortgage-backed securities. As of March 31, the average duration of the Vanguard GNMA was 2.6 years, which would place it in the short-term category. But there's a good chance that over the next few months this duration will extend, according to Russell. That's because with each mortgage-backed bond, there's so-called "extension risk," which is basically the level of interest-rate risk with mortgage-backed securities as calculated by how soon the mortgages are going to get paid off. As rates go down and people rush to prepay their mortgages or refinance, extension risk goes down. In a rising interest-rate environment, exactly the opposite happens. "That chance of prepayment goes away and they become a little bit more sensitive to interest-rate changes than they were before," Russell says.

Confused? Let's let the numbers talk. In 1994, when the Fed hiked the fed-funds target rate by 2.5 percentage points, the Vanguard GNMA lost 2.28% during the first quarter, but only 0.95% for the year. In 1999, when interest rates increased by three-quarters of a percentage point, the fund lost 1.22% during the second quarter, but actually earned 0.77% annually. And last year, when there were a lot of prepayments and rates were volatile, it lost 3.08% in July, but again ended up the year in pretty good shape, with a 2.09% annual return. "All in all, it hasn't done too badly," Russell says. There may be certain short-term volatility, but it's worth noting that the fund has never lost over a five-year period.

Vanguard Inflation Protected Securities (VIPSX)
The average duration of this fund was 5.3 years on March 31, which would put it in the intermediate-term category. But duration isn't a reliable guide to Treasury inflation-protected securities, or TIPS, because they don't respond to interest-rate changes in the same way as conventional bonds do, explains Evensky. Rather than the simple "rise in rates, fall in price" scenario, the price of TIPS moves as a function of what's called "real rates," or interest rates minus the market's expectations for future inflation. "They're just a lot more complicated in how the price is likely to change depending on what happens to the economy," Evensky says.

So how the fund will perform in the near future will largely depend on what happens to inflation. And that's "a bit more speculative these days," says Andrew Clark, a senior research analyst with Lipper. "Recently, the market became very hawkish on inflation.... (But) if economic data don't continue to support that hawkish view, TIPS will tumble."

That would be a first for the fund: Since its inception in 2000, it has never ended a year on the negative side. It's also worth noting that at 0.18% a year, its costs are lower than any of its rivals, which is extremely important in a taxable account, notes Morningstar senior fund analyst Eric Jacobson.

Vanguard Total Bond Market Index (VBMFX)
This index fund tracks the performance of the Lehman Brothers Aggregate Index, and therefore is well diversified. "It's an enormous fund, it's one of the biggest bond funds around, and for good reason," says Jeffrey Ptak, a senior fund analyst at Morningstar. "It's very cheap, and it provides wide coverage to the domestic bond universe -- in one fell swoop, investors get exposure to the Treasury market, agencies, to mortgages, to corporates, pretty much the whole nine yards."

Because of its built-in diversification, Clark recommends this fund for buy-and-hold investors. "If you're a passive investor, meaning that you only go and reallocate between equity and bond funds once a year, (you'd do well to) buy the whole market," he says.

Like any intermediate-term bond fund, however, this one comes with its fair share of interest-rate risk: Its average duration as of March 31 was 4.3 years, which means for every 1% hike of rates it will drop by roughly 4.3%. In 1994, for example, the fund lost 2.66% for the year. In 1999, it was down 0.76%. So this might be a fund that you could consider paring back. One low-cost alternative is a bond ETF.