Adjustable Rate Bond Funds Protect Against Rising Interest Rates

- Alan Lavine and Gail Liberman

Bond prices and interest rates move in opposite directions. So when interest rates rise, bond prices fall.

Adjustable rate bond funds may help this scenario. The yield on adjustable rate funds typically is reset periodically, while the share price remains fairly stable.

There are two major types of adjustable rate bond funds, both currently yielding in the area of 3 percent. Bank loan funds invest in senior secured debt of lower credit-rated companies. The loans are backed by the collateral of the company.

Adjustable rate mortgage funds invest in mortgage bonds, typically guaranteed by the federal government or its agencies.

Even though these investments tend to have stable share prices, they are not guaranteed. "Floating or adjustable rate investments may be a good place to park short-term cash to earn higher yields," says Scott Berry, Morningstar analyst. "But investors need to be aware that these investments are not risk-free."

For example, during the recession of 2001 and 2002, there were a large number of bank loan defaults.

In 2001 and 2002, bank loan funds eked out average gains of just 1.59 percent and .64 percent respectively.

And even though mortgage bonds are considered guaranteed by the federal government or its agencies, the bond fund shares are not. Fund share prices could fluctuate, causing you to lose principal. Managers can't just buy and hold mortgage bonds. They must make some adjustments due to financial conditions. Mutual funds firms with bank loan funds: Eaton Vance, Franklin and Fidelity.

Mutual fund firms with adjustable rate mortgage funds: AMF, Franklin, Evergreen and Federated.

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Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books). Al and Gail's new book is Rags to Retirement, (Alpha Books).