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How to choose the right bond fund for 2014

| Sunday, Jan. 12, 2014, 9:00 p.m.

When you stand outside at night and gaze at the stars, your mind turns to the big questions: What is our significance in the bejeweled vastness of space? Is there life in space? What will the yield on the 10-year Treasury note be this time next year?

Predicting interest rates is about as difficult as predicting an invasion of giant earwigs from Saturn. But if you own a bond fund — and millions of you do — then you should think about the direction, if not the level, of interest rates.

The Federal Reserve controls short-term interest rates, by controlling the fed funds rate. The fed funds rate, currently 0 percent to 0.25 percent, is the rate at which Fed-member banks lend to each other, typically overnight.

Why should you care? Because most savings rates, such as those offered by banks, track the fed funds rate pretty closely. The highest-yielding three-month bank CD, for example, pays just 0.45 percent, and the average money market fund pays 0.01 percent.

The bad news: Those rates are going nowhere this year. “We don't expect a change in fed funds rates,” says Michael Englund, chief economist for Action Economics. Most economists don't expect the Fed to raise short-term interest rates until the unemployment rate falls below 6.5 percent, which might not happen until 2015. If you're a saver and can't stand the thought of risk, you're going to have to wait until next year.

Until recently, the Fed didn't control longer-term interest rates, such as the yield on the bellwether 10-year Treasury note. The Fed's bond-buying program, called quantitative easing, or QE, changed that. By purchasing $85 billion in Treasuries and mortgage-backed securities every month, the Fed has kept long-term interest rates below what they would normally be.

At the Fed's latest meeting, however, the central bank announced it would taper back QE and buy fewer long-term securities this month. Presumably, the QE program will cease altogether by the end of this year. And that could mean that yields on the 10-year note will rise. How much?

Mark Zandi, chief economist for Moody's Analytics, thinks the 10-year T-note yield will inch up to 3.75 percent by the end of the year from its current 2.97 percent. Englund's estimate: 3.5 percent. Less bond-buying by the Fed is just one reason why.

Another is a rising economy. If gross domestic product grows and Congress does nothing to cripple the nation's credit rating, the economy could grow at 3 percent a year this year, vs. 2.8 percent in 2012 and 1.8 percent in 2011. On an annualized basis, GDP grew at a 4.1 percent in the third quarter, according to the Bureau of Economic Analysis.

A 3.75 percent or 3.5 percent 10-year T-note yield probably isn't enough to derail the housing rebound, Englund says: He expects mortgage rates to hit 5.1 percent to 5.25 percent at the end of 2014, vs. 4.51 percent the week of Jan. 9, according to mortgage giant Freddie Mac.

What does all this mean for a bond investor? First, that the trend of interest rates is up, and that's a bad thing for bonds. Bond prices fall when interest rates rise, and at current levels, your interest payments won't offset your bond fund's price losses.

When rates rise, long-term bond funds get hurt worse than short-term ones. For example, the 10-year Treasury note ended 2012 at 1.76 percent and climbed to 3.03 percent by the end of last year. The average long-term Treasury bond fund lost 6.7 percent last year, including reinvested interest, according to Lipper, which tracks the funds.

If you're worried about rising interest rates, you can move to a shorter-term fund. The average short-term Treasury fund dropped 0.75 percent last year, Lipper says. Ultrashort funds actually gained 0.44 percent.

You might consider moving to funds that own lower-quality bonds. Bond investors will push prices down if they think the odds of a default increase. But in a rising economy, the odds of payback increase and so do the prices of previously shaky bonds.

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