Markets

Investing in Mutual Funds: The Best Pick to Protect from Interest Rate Volatility

MoneyMorning.com Report - Investing in mutual funds is a powerful yet simple way for investors to achieve long-term financial goals with less risk than picking individual stocks. Mutual funds also offer a steady stream of income.

But today's best strategy for investing in mutual funds focuses on stability and yield, not just income.

And that's all because of the U.S. Federal Reserve.

No one can tell what the Fed's next move is going to be regarding interest rates. A strengthening dollar and deflationary pressures on the U.S. economy seem to support the U.S. Federal Reserve 's protracted low-rate policy. But at the same time, labor market indicators are clearing up. About 295,000 jobs were added in February and the unemployment rate sits at 5.5%. That adds fodder to the Fed hawks' calls to raise rates.

This uncertainty will fuel interest rate volatility in the near future. But a solid mutual fund investing strategy will preserve capital and protect against these potential wild rate swings.

"Many investors challenge me on the notion of stability when I am speaking at conferences every year, especially as it relates to income. They'd rather chase yield," Money Morning Chief Investment Strategist Keith Fitz-Gerald said. "Yet, stability means you never have to worry about making up money you don't lose in the first place."

Investors won't get that stability by going after the high-yield , longer-term bonds. At least not in today's investing environment.

That's why the best place for the mutual fund investing crowd to put their money to work right now is on the lower-end of the yield curve...

Investing in Mutual Funds for "No Drama"

U.S. Global Investors Near-Term Tax-Free Fund ( NEARX ) is a five-star municipal bond fund with a solid track record. It's generated positive returns for its clients every year for the last two decades.

Only 0.12% of funds can lay claim to such a feat, according to U.S. Global Investors.

That's why Fitz-Gerald told investors about it in November.

Of NEARX's $89.5 million in assets, about 90% is invested
in U.S. municipal bonds.

"It's my favorite 'no-drama' - or to be more precise, 'anti-drama' - investment, and has been for some time," Fitz-Gerald said.

Of NEARX's $89.5 million in assets, about 90% is invested in U.S. municipal bonds.

"Munis, generally speaking, are just an overlooked asset class," John Derrick, Director of Research at U.S. Global Investors Inc. (Nasdaq: GROW) and a fund manager for NEARX, told Money Morning . "It's a little messier market but over time they perform phenomenally."

Munis fly under the radar for many investors because the market is fragmented. It's also not as standardized when compared to other asset markets.

But munis are attractive because the interest rate returns are exempt from federal income tax. This offers great tax-adjusted returns against comparable yielding investments that don't have that luxury.

Muni bears will point to the high-profile 2013 bankruptcy of Detroit as a case against these bonds. But data shows that Detroit is an extreme exception to the rule. Moody's Investor Services rated 8,800 municipal bonds between 1970 and 2013. Of those, only 80 - or 0.9% - defaulted.

The other 10% of NEARX's assets is in cash. This cash is replenished by constant maturity payments of short-term securities, providing a lot of liquidity to the fund.

21.2% of NEARX's holdings mature in less than a year. The average maturity of the fund's holdings is 2.44 years. And when NEARX's managers see unusual patterns in bond market volatility, that's when they'll sell to up their cash hoard, or buy to find bonds on the cheap.

NEARX is one of several municipal bond funds that take advantage of the favorable tax treatment and stability of the asset class.

But here's why NEARX stands out among the muni crowd...

Preparing for Interest Rate Hikes Through Mutual Fund Investing

Right now, the Fed is teasing higher interest rates. And what's worse, they aren't exactly coming clean on a timeline for expected rate hikes. That's why preparing for interest rate volatility is paramount.

That's what NEARX has been doing and continues to do. Fund managers are shortening the maturities of its holdings - after all, the longer the maturity, the greater the price volatility. Longer maturities do yield higher returns, but even a slight adjustment in rates can be devastating to the face value of bonds.

For example, a mere 0.25 percentage point increase in rates can sink the price of a 2-year Treasury as much as 0.5%, according to Bloomberg . But that price drop becomes more pronounced on a higher-yielding 30-year Treasury. Those securities stand to get whacked as much as 2% by the same rate hike. This hit to a bond's value only becomes deeper the higher rates rise, as the accompanying chart shows. Remember, a bond's face value moves in the opposite direction to its interest rate.

"If you are worried about interest rates going up you don't really want to be on the long end of the yield curve - you want to be on the short end of the curve," Derrick said. "Preserve your principal; preserve your capital; live to fight another day."

And NEARX has a further advantage. It's relatively small. NEARX's $89.5 million in assets pales in comparison to similar funds like the USAA Tax-Exempt Short-Term ( USSTX ) and its $2 billion in assets.

This allows NEARX's managers to work closely with regional brokers across the country. They can take advantage of so-called "odd lot" bond offerings. This is when brokers will sell bonds in a block smaller than a traditional offering. Larger funds typically won't chase these offerings because they're too small to have an impact on their holdings.

"A bigger fund group will say, 'Well, I only want to buy $1 million or $5 million in bonds at a time,'" U.S. Global Investors CEO and CIO Frank Holmes told Money Morning . "We'll buy that $380,000 in bonds and get a better yield on it because it's an odd lot and brokers just want to get it off their books at the end of the day.

"We're able to be that high quality, high value 'jewelry' collector," he added.

The Bottom Line: Right now isn't the time to be chasing yield. Investors are staring down potential rate hikes by the Fed. That will only increase interest rate volatility on those higher-yielding, longer maturity instruments. That's why a "no-drama" fund like NEARX, whose fund managers are actively working to position their fund for less interest rate sensitivity, is your best bet for a steady, predictable return.

Having personal debt is the American way...it makes the impossible possible. It's seen as benign or even good. It's not. But as an investor, there is one instance where you should consider taking on debt. There's one instancewhere debt can even be profitable....

To get full access to all Money Morning content including our latest Premium Report, "How to Make 2015 Your Wealthiest Year Ever," click here

About Money Morning: Money Morning gives you access to a team of ten market experts with more than 250 years of combined investing experience - for free . Our experts - who have appeared on FOXBusiness, CNBC, NPR, and BloombergTV - deliver daily investing tips and stock picks, provide analysis with actions to take, and answer your biggest market questions. Our goal is to help our millions of e-newsletter subscribers and Moneymorning.com visitors become smarter, more confident investors.

Disclaimer: © 2015 Money Morning and Money Map Press. All Rights Reserved. Protected by copyright of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including the world wide web), of content from this webpage, in whole or in part, is strictly prohibited without the express written permission of Money Morning. 16 W. Madison St. Baltimore, MD, 21201.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

In This Story

USSTX NEARX GROW

Other Topics

How to Invest

Latest Markets Videos