Good news for the economy could be very bad news for bond investors this year.
It may come as a shock to the unprecedented number of retail investors who—fleeing the stock market and seeking stability—have poured their savings into fixed income over the past year, but rising interest rates can hurt the value of bond investments. With the U.S. Federal Reserve holding its federal funds rate near zero, short-term rates have nowhere to go but up. The Fed said in a statement on Apr. 28 that it expects "exceptionally low levels of the federal funds rate for an extended period," but an improving economy could cause the Fed to change its stance. Economists' predictions vary, but typical is Jefferies Fixed Income's prediction that the Fed will begin raising rates in the first quarter of 2011.
Although the economic environment still feels bleak to many Americans, a rebound could be swift, especially if stimulus from the Fed and the federal government proves successful. Data released on Apr. 30 showed that U.S. gross domestic product grew at an annual rate of 3.2 percent in the first quarter of 2010. "Once those sparks catch fire, it's going to be a quick turn in the economy," predicts Lorenzo Newsome Jr., chief investment officer at Xavier Capital Management in Largo, Md. That will push up interest rates by the end of 2010 and "cause the value of investment-grade bonds to fall," he says.
Feeling the impact could be millions of new, inexperienced, fixed-income investors. According to TrimTabs Investment Research, investors poured $467.2 billion into bond mutual funds in 2009 and a further $115.8 billion so far this year. By contrast, an average of $43 billion flowed annually into bond funds from 2003 to 2008.
"It's a bond fund bubble," says Marilyn Cohen, chief executive of Envision Capital Management in Los Angeles and author of the book Bonds Now!: Making Money in the New Fixed Income Landscape. Most of these new fund owners are "unsophisticated investors" who are unaware how much rising rates can hurt bonds, she says. (Because institutions and wealthy investors tend to buy securities directly, mutual fund customers tend to be retail investors.) "If we get a big spike in rates, there will be a mass panic," Cohen says.
Given the events of the past three years, individual investors' preference for bonds is understandable. Cash in money markets currently offers miniscule returns, while the U.S. stock market's perils became all too clear in 2008 and early 2009. According to TrimTabs, $11.9 billion has been pulled from U.S. equity funds in the last 12 months, even as the S&P 500, the broad stock market index, rose 76 percent since Mar. 9, 2009.
"Before 2008, people were not really recognizing the risk in equity markets," says Eric Meermann, financial planner and portfolio manager at Palisades Hudson Financial Group in Scarsdale, N.Y.
Now, many may not recognize the risk in bond markets. "We foresee a rising interest rate environment, and investors need to be aware of the risks associated with that," says Ron Florance, director of asset allocation and strategy at Wells Fargo Private Bank (WFC).
Bonds vary widely but there are two main types of risk embedded in all fixed income products: credit risk and interest rate risk. Credit risk is the risk that a bond issuer will not be able to pay, a possibility with which investors in Greece's government debt are currently contending. Interest rate risk is the possibility that—because of Federal Reserve action, a stronger economy, or fears of inflation—rates could rise.
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