Your Money: For bond investors, the Fed's moves matter

Shredded currency surrounds the seal of the U.S. Federal Reserve in Washington. ANDREW HARRER / Bloomberg News
Shredded currency surrounds the seal of the U.S. Federal Reserve in Washington. ANDREW HARRER / Bloomberg News
Posted: May 01, 2013

Ahead of the key Federal Reserve meetings Tuesday and Wednesday, bond investors are asking themselves a hard question: What will happen when inflation and interest rates inevitably rise and bond prices fall?

The Fed, to a large extent, has kept interest rates at rock-bottom levels, so bond investors are holding their collective breath to see what the agency decides next.

If rates rise, the market value of government bonds in particular - and all bonds in general - could be hurt significantly. For example, if the federal funds rate rises to 3 percent, a longer-term Treasury bond might lose as much as a third of its market value.

For every 1 percent increase in interest rates, expect the 10-year U.S. Treasury bond to lose 8.96 percent in price.

Historically, the 10-year Treasury bond returned a long-term average real rate of return and yield of 4.4 percent, according to Don Riley, chief investment officer of the Wiley Group. If the 10-year yield rose from 1.66 percent today to 4.4 percent, the price of that bond would fall 21 percent.

If and when interest rates rise again, are bond owners going to keep 10-year or 30-year Treasury bonds in their portfolios until those bonds mature? Very likely not. Who would want a 1.5 percent or 2.5 percent return for a decade?

In the meantime, there are few places to hide. In comparison to government bonds, even longer-term corporate bonds have, in recent months, offered only a 3.5 percent to 4.0 percent return.

What if you want a fixed-income stream and need to stay in bonds? Some money managers, like Ed Kohlhepp of Kohlhepp Advisors in Doylestown, believe now is the time to rotate out of long-term and into short-term bonds to avoid a massacre.

What's the trade-off in that move? We investors are paid lower interest rates in exchange for a potentially smaller drop in the market value of these securities, if rates should rise.

If you are after higher rates of return from short-duration bonds, Kohlhepp says to look to bonds that are investment-grade but slightly lower credit ratings, below AAA or AA ratings. Investment-grade corporate bonds, for instance, return roughly 2.5 percent.

Other advisers believe it's unlikely the Fed is going to raise rates this week or announce it is tapering off bond purchases, which have buoyed the market, says Joe DiGiammo of Mischler Financial Group of Boston.

The mantra of bond investors since the 2008 financial crisis has been "Don't fight the Fed," and so far the Fed has been keeping a floor under bond prices by acting as the largest buyer. DiGiammo thinks the Fed "may not increase bond purchases, but I think most of us can agree that current purchases in place are not ending in the near future."

More likely, he says, the Fed may decide to simply hold to maturity the Treasury and mortgage bonds it has bought, creating a floor under the market.

DiGiammo believes investors looking for income should instead turn to the real estate sector. "We're not yet at the top here, whether we're talking commercial mortgage-backed securities and real estate investment trusts," he said. A good proxy "for dummies like me," he adds, is a diversified index like iShares Dow Jones U.S. Real Estate Index Fund (IYR).

'Retirement Gamble'

Normally, I don't plug television shows, but this one I can't recommend enough: The Retirement Gamble premiered last week and can be seen on PBS Frontline. The program examines how one out of three Americans has next-to-no retirement savings, and includes interviews with our homegrown mutual-fund guru, John Bogle, founder of Vanguard. The program explores how hidden fees, self-dealing, and conflicts of interest are endangering a stable retirement for millions. If you can't see a repeat, watch it online at PBS's website ( www.pbs.org/wgbh/pages/frontline/retirement-gamble).


Erin Arvedlund is a finance reporter and lives in Philadelphia. Contact her at erinarvedlund@yahoo.com or 646-797-0759.

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