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Rising rates could drop bond lovers in the hole

Gail MarksJarvis
| Monday, Aug. 23, 2010

The Dow Jones industrial average rose 104 points Tuesday and fell 144 Thursday. Many investors have turned away from a stock market they deeply distrust, with many seeking security in bonds.

"People are skeptical," said Charles Kantor, senior vice president at financial manager Neuberger Berman. "They have no appetite for the stock market."

But Kantor is among professional investors trying to convince individuals that they could hurt themselves if they rely too heavily on bonds, especially the Treasury bonds considered safest. Since 2007, investors have pulled billions out of stocks and poured the money into bond funds.

At first it was for safekeeping, but the popularity of bonds has been reinforcing. Instead of stocks outperforming bonds as they have over more than 80 years of history, Treasury bonds have been the clear winners in a 10-year period. People holding 10-year Treasury bonds during that time would have gained about 6.3 percent a year on average while losing 0.8 percent in the Standard & Poor's 500 stock market index. And in this year alone, investors have lost about 2 percent in the stock market while gaining about 9 percent in 10-year bonds.

Financial advisers say it's been tough to talk clients out of putting most of their money into bonds. "It's not popular to talk about stocks," Kantor said.

At Northern Trust, chief investment strategist Jim McDonald said, the company has adapted to people's stomachs for risk. Virtually every type of client is holding a smaller portion of their investments in stocks than they did prior to the market crash that began in 2007.

People are more concerned with preserving their money than growing it, McDonald said.

After stocks sank in June, 401(k) investors in July withdrew another $440 million from stocks and stock mutual funds and put the money into stable-value funds and bond funds, according to Hewitt Associates.

But as investors cling for safety in 10-year Treasury bonds, despite yields of about 2.7 percent, analysts fear they will eventually be shocked by losses.

"They think they can't lose money in Treasurys, and they could be sadly mistaken," said Jim Floyd, an analyst for the Leuthold Group, a firm that researches stock and bond markets.

He notes that investors have been making oversized gains because interest rates have been trending down for years. When that happens, the bonds people and funds already own increase in value, because the old bonds pay higher interest than newer bonds.

Rates are unusually low now because of the fear of recession and deflation. As those fears ease, Floyd and others expect interest rates to rise, surprising investors with losses.

Recently, the risk of such a loss has seemed unlikely. The Federal Reserve has indicated it intends to keep interest rates down for a while. As long as deflation, rather than inflation, appears to be a risk, interest rates are expected to stay down.

But that isn't enough to comfort bond manager Marilyn Cohen of Envision Capital Management. She said interest rates could start rising even if the Federal Reserve doesn't raise rates, because investors might demand more interest to compensate them for taking the risk on everything from Treasurys to municipal and corporate bonds.

Gail MarksJarvis is a personal finance columnist for the Chicago Tribune and author of "Saving for Retirement Without Living Like a Pauper or Winning the Lottery." Readers may send her e-mail at gmarksjarvis@tribune.com.

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