Duration will be the main issue for canny investors wishing to keep part of their portfolio in bonds when interest rates rise. Bank of England governor Mark Carney hinted last month (11 Mar) that the base rate could rise six-fold to 3% by 2017, a move that would hit bond prices.

When interest rates rise bond yields fall as investors move their funds into less-risky classes such as cash. As a rule of thumb, the longer the paper has until maturity the more its yield will fall, while those holding paper maturing in four years or less will experience limited impact.

A bond with 10 years left to run, for example, would lose 20% of its price if there was a 2% interest rate hike. In the same environment the price of paper with two years until the principal is repaid could fall 4%. Short-dated bonds are ideal for a low-risk investor wanting to maintain a diversified portfolio.

The attraction of this strategy has increased following changes to the Individual Savings Account (Isa) rules. From July investors can boost their returns by keep bonds maturing in five years or less along with longer-dated paper in the tax wrapper.

Is it worth it?

But investors need to think before they dump their long-term holdings and rush into shorter-life bonds. They will be moving down the yield curve and will typically collect a lower coupon until the principal is repaid.

There are other issues. The first is that the market continues to perform strongly with the bonds on the Order Book for Retail Bonds (ORB) trading above par value, which is the price they were sold for in the primary market. This limits the opportunity to make capital gains, where the trick is to sell when a bond is trading above par and buy when it falls below its starting price, which is typically £100. So a loss will be made by those looking to reduce the impact of an interest rate rise.

Lack of supply is another issue. In the past 12 months only six new retail bonds have been issued meaning that there are only three bonds with the longest maturities on the market at eight years. So the likelihood is that many investors will be holding bonds that have five or six years left to run.

The ideal conditions for investors increasing their exposure to short-dated paper would be to have several such bonds to choose from trading below their nominal value.

Strength in numbers

Considering some of the issues above, investors need to consider if taking a coupon and capital gains hit is worth trying to avoid the impact of an interest rate rise. The difference between these products could be minimal. Indeed, switching from A2D Funding 4.7% Oct 2022 (A2D1:ORB) into Lloyds Banking 5.5% Sept 2016 (LBG2:ORB) offers a small gain for the next two years, although the shorter bond trades at 106.3, and above par. It could be that interest rates will hit their investment pot anyway if investors are paying into a pension or hold equity in a life insurer. Such companies need to back long-term fixed-income products to cover their long-term liabilities.

If investors feel it is worth easing the burden of an interest rate rise they could put their money into a short-dated bond fund. There are several to choose from on sites such as www.morningstar.co.uk, offering research on investment strategy and fees.