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Anticipation of rate increase worries bond investors

Gail MarksJarvis
| Monday, March 29, 2010

Should you duck to avoid getting smacked by the bond market• And if you do, will your stocks get roughed up too?

As investors start to anticipate rising interest rates, analysts are concerned about stocks and bonds.

Although the Federal Reserve has said it plans to keep rates at rock-bottom levels for an "extended period," many strategists assume policymakers will start to wean the economy from the low rates in about six months, and they predict volatility in stocks and bonds as trepidation builds.

Rising interest rates are especially hard on bond investors. If they are holding bonds with low rates, they can lose money because new, higher rates available in the marketplace are more attractive to investors than those on bonds already in their portfolios.

Investors with old bonds, including bond mutual funds, might not be able to sell the low-interest bonds in a rising-rate environment unless they are willing to accept a lower price than they paid. And because 10-year U.S. Treasury bonds are yielding just 3.68 percent and municipal bonds also are paying little interest, rising rates could be harsh on investors lulled by bond funds' strong returns the past couple of years.

Brad Tank, fixed-income chief investment officer at Neuberger Berman, said investors in bond funds "could easily have a few quarters of negative returns."

Morgan Stanley strategist Jim Caron said, "We expect yields to rise sharply." The sharper the increase, the greater the potential for damage to investors holding low-interest bonds such as Treasurys and municipal bonds.

In anticipation, bond investors are feeling cautious. As Morgan Stanley strategist Rizwan Hussain has met with clients lately, he said, they worry about "a wholesale rotation out of fixed income altogether and into equities or alternatives."

Because investors can choose between stocks or bonds, the concern is that bond values could be injured if investors shy away from them in anticipation of potential losses. But in the long run, high interest rates can play havoc with stocks, too, as companies face stiffer interest rate charges on money they borrow for operations. The higher interest charges erode company profits. Likewise, home buyers can be priced out of the home market if mortgage interest rates jump.

Recently, however, the stock market has been on a gentle rise, with the Dow industrials up 16 of the past 20 sessions. The Dow gained more than 100 points Tuesday, and hit a 17-month high. The benchmark Standard & Poor's 500 index is up 5.3 percent in 2010. Analysts, however, think the uncertainty about the future might be one reason the stock market has trickled higher with little volume.

As the economy shows increasing strength and the likelihood for higher interest rates increases, Caron said he believes investors will change course after flooding bond funds with a record amount of money during the past couple of years, and start looking to stocks.

Tank's advice to investors: Stay with short-term bond funds because bonds that mature quickly are less likely to lose money as rates rise. High-yield corporate bonds also can be less susceptible, although they will be at risk if investors expect rising rates to weaken the economy. Solid dividend-paying stocks also have appeal, he said.

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