In a Fed-tightening cycle, bond investors can minimize or even profit from a jump in interest rates in several ways. Even if the Fed does not embark on an aggressive rate-increase cycle in 2016, these vehicles make sense in the current uncertain market environment.

Short-Term U.S. Treasury Notes

Duration is the sensitivity of a bond's price relative to a change in interest rates. The higher the duration, the faster a bond falls in a Fed-tightening cycle. For instance, a Treasury note with a three-year duration experiences a principal decline of about 3% with a 1% rise in rates. In an extended tightening period, yields rise faster on these notes compared to long-term Treasuries, but the low duration limits the impact on principal provided the Fed does not go into an extended cycle of raising rates.

Over the last five tightening cycles beginning in 1986, the Fed raised rates by an average of 2.7% per cycle. No one expects Federal Reserve Chair Janet Yellen to follow that precedent in 2016, but a strategy of creating a ladder is a way to combat that possibility. Investors create a bond ladder by buying a portfolio of bonds with different maturities. In a rising-rate situation, the proceeds from maturing bonds are reinvested in bonds with higher yields.

Meanwhile, there is a big difference between buying individual bonds in a ladder compared to buying a short-term bond mutual fund. If an investor holds an individual bond to maturity, yield income and principal is guaranteed. However, a bond fund's portfolio net asset value (NAV) is constantly fluctuating, and there is no maturity date where the initial principal is guaranteed to be returned. Redeeming shares of a fund may result in a gain or loss depending on market conditions and the interest rate environment. Many investors learn this lesson after cashing in a bond fund during a particularly aggressive Fed-tightening period.

Short-Term Investment Grade Corporate Bonds

Corporate bonds are often more resilient than Treasuries in a rising interest rate environment because they usually provide higher yields. A Barclays index of short-term corporate investment-grade bonds maturing in one to three years shows a two-year duration. Yield to worst is 1.3%, the lowest yield that can be received on a bond without the issuer defaulting. Laddering could be used on a diversified portfolio that includes both Treasuries and investment-grade corporate bonds.

The same warning about buying a mutual fund instead of individual bonds applies. If an investor sells the fund when market rates are shooting up, a big capital loss is possible. Even worse, if the economy falls into a recession, corporate bonds issued by cyclical companies get battered. Investors in funds holding illiquid assets have an incentive to withdraw early as NAV plummets, pushing portfolio managers to sell assets to meet redemption requests.

The advantage of a mutual fund is diversification. If building a portfolio of short-term corporate bonds, it is critical to research the issuer so an investor is not stuck with another oil-and-gas debacle where principal goes into a death spiral.

Long-Term U.S. Treasury Bonds

The conventional wisdom is that when the Fed raises rates, short-term Treasuries are the place to put money to work, but this is not always the case, especially if inflation is under control as it is in 2016. Indeed, Yellen is more concerned about already-low inflation moving toward deflation. Inflation erodes longer-maturity bonds the most, yet in the current environment, a Fed-tightening campaign should force inflation even lower. The Treasury yield curve, defined as the difference between two- and 10-year bonds, flattens as short-term rates head higher and long-term rates move down. A flattening curve is bullish for Treasuries with maturities of 10 years or longer. There was a very good example of this during the Fed's 1993 to 1994 tightening campaign.

Jeff Gundlach, Barron's "King of Bonds," notes that in 2013, sentiment was growing that the Fed would hike rates, yet long-term Treasury yields trended down during 2014. By year end, the 10-year yield was 2.2%, down from 3%. “The long bond wants the Fed to tighten,” Gundlach comments. Almost any Wall Street fixed-income specialist bullish about long-term Treasuries during the Fed's tightening cycle cites the same rationale. If inflation stays quiescent, the long end of the curve does well.

The Bottom Line

Even if Yellen is "one and done," raising rates only once and stopping due to the rout in the stock market, at some point, the Fed will go into a normal tightening phase. These bond strategies will remain useful when that day arrives.