Despite their calm words , bond managers can't be sleeping well—what with their worries about interest rates and inflation, the housing market and municipal bankruptcies keeping them up at night.
So just when will this bond bubble burst? Treasurys are as expensive as they've ever been; bond king Bill Gross, manager of Pimco Total Return, the world's biggest bond fund, called the end of the 30-year rally in bonds way back in October; and the Federal Reserve's program to snap up Treasurys in hopes of reviving the economy could end in June without further government action. And still nothing catastrophic has happened. But smart financial advisers and fund managers are diligently watching for signals that the end is near and so should you. Ironically, good economic news--such as an improved housing market or increased consumer spending--could be disastrous for your bond portfolio. Here then are five key signs too look for that could signal the bond market is taking a turn for the worse.
1. A rise in interest rates.
Let's face it: Interest rates can't get much lower after falling steadily for the past three decades, so a hike is coming sooner or later--and that's bad news for bonds, especially Treasurys. If employment and consumer spending improve, the Federal Reserve is likely to lift interest rates to control inflation, says Greg McBride, a senior financial analyst at Bankrate.com. Higher rates could decrease the value of existing bonds because investors would likely flock to newer issues with higher yields.
Another reason higher rates are bad for bonds is they would likely mean more competition from insured bank products, which have been earning next-to-nothing in recent years. An upward tick in rates would suddenly make certificates of deposit, money market accounts and high-yield savings accounts more attractive to older and risk-averse investors.
Longer term bonds, especially U.S. government bonds, and bond funds, would see the biggest hit if interest rates rise because over the long-haul the higher rates would diminish the value of the bonds. Something as small as a one-percentage-point hike would send the average 10-year Treasury bond down about 8%, says McBride. "If interest rates go up two percentage points, that's a 16% loss."
Investors should stay tuned to the Federal Reserve monetary policy meetings, which occur eight times a year and often reveal news about rate changes and Fed policy on Treasury buybacks. The next meeting is scheduled for March 15. And beware: Interest rates could rise even if the economy remains sluggish, experts say.
2. Signs of inflation or deflation.
Concerns about deflation have eased in recent months as consumer spending has improved, but if the economy continues to heat up, it could stimulate inflation as more dollars go toward buying clothing, food and other products. Economists are particularly concerned that this buying spree could come from abroad – especially developing countries – in the form of higher prices for oil and commodities.
"Inflation is to the bond market what kryptonite is to Superman," says McBride, because it erodes the value of a bonds' fixed payment.
Rates on longer term Treasurys – such as 10-year and 30-year bonds – are more driven by inflation expectations, says Steve Huber, manager of the T. Rowe Price Strategic Income Fund ( PRSNX ) . At the end of 2010, for example, rates climbed as investors became more worried about inflation. On the other hand, deflation makes Treasurys more attractive, but could be bad news for non-government bonds because issuers may have trouble making payments. Even when businesses earn less because of deflation, they have the same bond obligations, notes McBride. Investors should keep an eye on the Consumer Price Index, released each month by the Bureau of Labor Statistics.
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