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Friday, June 28, 2013 - 08:30

Worried About A Bear Market In Bonds? Read This

Friday, June 28, 2013 - 8:30am

Interest rates remain near historic lows. And when they eventually rise, bond prices will fall, as the two move opposite to each other. The question of how much they will fall over the long term is important to investors. The last time rates were this low was in the 1950s. We can look at bond returns from that time for clues as to what will happen this time.

Federal Reserve data on 10-year interest rates extend back to 1954, when the yield on the 10-year Treasury note was about 2.5%. That rate would rise to near 15% by 1981.

As rates rose over that 27-year period, bond prices fell. However, bond investors did not suffer extraordinary losses.

As rates rose, investors received higher interest payments as they rolled over old investments into new bonds. Looking at the average rate of return from 1957 to 1981, we learn that bond investors made money. In fact, they more than doubled their money over that time.

Over that long period of time, investments in stocks, bonds and Treasurys all made money.

These returns include interest payments and the gains and losses from price changes, which make up the total return a bond investor actually receives.

It is important to note that fixed-income investors made money in an environment of rising interest rates, because eventually, rates will rise. When rates do rise, we can see, with history as a guide, that investors may not suffer as much harm as they fear.

The gains in bonds were not extraordinary, and investors lost money in eight of the 27 years. Stock market investors also lost money in eight years over that time but enjoyed significantly larger gains overall. Investors in Treasurys accepted what are considered to be low rates of return and never suffered a loss over the course of a year.

While never experiencing a losing year, Treasurys also outperformed long bonds. This is a lesson that is likely to apply during the next period of rising rates. Fixed-income investments with shorter maturities can be reinvested quicker than long-term investments. This allows short-term investments to benefit from rising rates.

Fixed-income investors should consider using ETFs or mutual funds that have a large number of holdings. Managers of these funds will be rolling over investments throughout the year as some investments mature. This could allow them to enjoy quicker benefits from rising rates. Fund managers may also be able to sell some lower yielding investments to move into higher yielding investments as rates rise, a move that might not be practical or cost effective for an individual investor with a limited number of holdings.

In the table below, returns on Treasurys and the other investments are shown without considering inflation. When inflation is considered, the Treasury investor does suffer a loss in several years.

Over the entire time period, an investor in Treasurys would have had an after-inflation average annual gain of 0.73%. Investors in long bonds over that time also lost money after inflation.

Fixed-income investors should consider using short-term bond funds if they expect rates to rise. The best exchange-traded fund (ETF) for government bonds right now, in my opinion, is iShares Barclays 0-5 Year TIPS Bond (NYSE: STIP).

PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSE: HYS) is among the best choices for corporate bond exposure, and PIMCO managers have demonstrated the ability to react quickly to changing market conditions.

Even when rates rise, fixed-income investors may not suffer steep losses over time, especially if they use ETFs that give the manager flexibility to take advantage of higher rates.

Note: Michael J. Carr has devised a simple system that tells investors exactly when to sell stocks before they tumble. Even better, his system has generated an average annual gain of 21.5% during the past decade -- trouncing the S&P's measly 7.3% gain. To learn more, click here.

This article originally appeared at ProfitableTrading.com
How to Protect Yourself in the Next Bond Bear Market

Michael J. Carr does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.