The good news for income investors is the Federal Reserve just reaffirmed the central bank is likely to begin raising interest rates in September. Although the Fed gave itself ample wiggle room to delay raising rates, we believe monetary policy will finally start returning to normal and that a rate increase is now more than likely to happen later this year.

This is great news for income-starved investors. But keep in mind it also means bond prices will take a hit because they have an inverse relationship with interest rates. When interest rates rise, bond prices usually fall, and when interest rates fall, bond prices usually rise.

Still, don’t avoid bonds. Now is the time to embrace bond market opportunities to both preserve wealth and deliver income.

Of course, our own Global Income Edge portfolio of strong, dividend-paying stocks will continue to offer great income for investors, but we do see opportunities developing for higher yields in some bond markets.

A note of caution: Investment experts including Warren Buffet consider the bond market overvalued, and bond prices will have to come down even more before cautious investors should consider them.

The drop in bond prices and the rise in interest rates started mainly because central banks stopped buying bonds aggressively (they did so to pump money into their weak economies to stimulate them). Deutsche Bank recently noted that 2015 will go down as the year when central banks lost “their willingness to distort and manipulate markets.”

This new strategy led to the grueling bond market rout that started in May, wiping out more than $450 billion of bond value worldwide. That hurt current bond holders’ principal, but the flip side is higher interest rates.

Led by the German bund (the German equivalent of the U.S. Treasury bond), the bond rout drove interest rates to eight-month highs. The 10-year U.S. Treasury peaked at 2.42% before slipping back to 2.33%, CNBC reported. Even corporate, investment-grade bonds and high-yield (junk) bonds were affected, with one measure of corporate bond yields peaking at 3.39% at the end of June—the highest level since October 2013. 

The exodus from bonds as well as the drop in prices has been stark. According to Bloomberg, Black Rock’s $14.3 billion high-yield bond exchange-traded fund (ETF) plunged 1.6% in six days in early June as $940 million exited the fund. Also, State Street Corp.’s $10.7 billion junk debt ETF dropped 1.7% during that same period, with $571 million in withdrawals.

Although bond values recovered somewhat, we think tighter monetary policy from central banks means not only much more volatility in bond markets but also many more investment opportunities for higher yields. 

Higher yields will hurt stock prices. As corporations pay higher yields on debt, they’ll have less money to in invest in their companies, buy back shares or raise dividends.

So rising rates mean not just looking for good bond values but expecting less from your stocks.

A Different Bond Market

Investors also should understand that the bond market has changed significantly since the global financial crisis of 2008. Given low rates, companies floated lots of bonds, but stricter financial regulations also made bonds harder to trade.

Markets are likely to become more volatile, especially for junk bonds, which may be hard to unload if there is a mass sell-off, according to J.P. Morgan. So be careful buying high-yield bonds, as you may be stuck with them or forced to sell them at a painful loss.

Except in certain circumstances, we are not big fans of bond funds, which some experts have been pushing. (See my colleague Ben Shepherd’s report on bond funds that we do like on page 3.)

We generally don’t favor bond funds because although they can reinvest in higher-yield issues as rates rise, thereby increasing the overall yield, these investments lack a final maturity date, offering no guarantee that the principal will be returned. And depending on the fund’s composition, the total return may go down as rates rise. Finally, bond funds will also suffer from this lack of liquidity.

New Market Strategies

That’s why we recommend holding short- or intermediate-term bonds in high-quality portfolios to preserve wealth and income. Individual bonds are impervious to volatility if you hold them until maturity, and if they have high credit ratings, you should get your principal back.

You should also be sensitive to the duration of your bond or bond fund. Duration, stated in years, is a measure of interest rate sensitivity. The longer the duration, the more a bond will drop in value as interest rates rise. Bonds with longer durations carry more risk and have higher price volatility than those with shorter durations.

In addition to duration, your bond portfolio should be well-diversified for safety and lower volatility. So hold various types of bonds, from government bonds to corporate bonds in solid sectors of the economy, with different maturities and yields.

As for investors seeking high-quality corporate bonds, I would suggest reviewing those issued by the electric utilities and telecoms in our Global Income Edge Conservative portfolios. As we have pointed out before, these firms have economies of scale, pricing power and, more importantly, high-quality credit.

Still, we caution readers not to over-concentrate their exposure to any one company by investing heavily in both its stocks and bonds.  Plus, keep in mind that some of these companies could offer higher yields from bonds than from stocks.

We found that electric utilities, such as our favorites Southern Company (NYSE: SO) and National Grid (NYSE: NGG), and telecoms such as AT&T (NYSE: T) and Vodafone (NYSE: VOD) all offer different types of investment-grade debt.

In addition to the usual corporate bonds, these firms offer a type of bond known as a debenture, which pays a higher yield because it’s only secured with the company’s credit. These firms also offer convertible bonds, which can be converted into company stock. There are also bonds that can be issued against a specific subsidiary or business, which sometimes pay higher yields than the parent company.

Over the next few months we plan to develop a proprietary bond fund that will help readers preserve wealth and income in these unpredictable times.

Lower the portfolio’s risk. Investors should re-evaluate the sensitivity of their bond holdings to interest rates and move to shorter-term maturities that are less vulnerable to rate increases.

Focus on quality. Buy high-grade or investment-grade bonds. Investors with junk bonds or high-yield investments may lose more principal in a market sell-off where there are fewer buyers.  

Cash is king. If you can, cash out of overvalued bonds and set the money aside for higher-yielding opportunities that will come along when bond prices fall.

Diversify. A diversified stock and bond portfolio has no substitute. Ask your financial adviser what the ideal mix should be for your circumstances.

Rethink stocks. With bond yields rising, so too is the cost of debt servicing. Because some companies won’t be able to pay as high a dividend or deliver the same income as they used to, only have the highest-quality income investments in your portfolio.