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Why bond investors are nervous

By Sheyna Steiner · Bankrate.com
Wednesday, June 12, 2013
Posted: 9 am ET

Shouldn't it be time to party if rates may go up? Not if you already own bonds or bond funds. The yield on the 10-year Treasury note is up quite a bit since the end of last month. According to the Treasury Department, the 10-year note was yielding 2.01 percent on May 21. On Tuesday, the 10-year yield was 2.21 percent, according to Bloomberg.

That's a significant change over a short period of time, particularly given the context. Bond yields fell after Federal Reserve Chairman Ben Bernanke talked about tapering the third round of quantitative easing. Plus, the minutes of the last meeting of the Fed's rate-setting committee indicated that some members feel next week's meeting could be a good time to start reducing asset purchases. That could take pressure off of interest rates, which means higher bond yields in addition to higher borrowing costs.

"It’s a direction that everyone anticipated but at a speed that took us a little bit by surprise," says Donald Cummings, founder and portfolio manager at Blue Haven Capital in Geneva, Ill.

"Should we run out the door? That is essentially what is going on. Everyone is concerned that the Fed is going to reduce bond buying. The major concern is that the artificial fire might leave the market," he says.

That leaves bond holders in a lurch. Bond prices move in the opposite direction as yield. If yields go up, prices on existing bonds go down. If the bond is held to maturity, the investor will get the face value, but in the interim, their statement will show that it has gone down in price.

There are a couple of things fixed-income investors can do to mitigate the coming volatility from rising interest rates.

"If they anticipate that rates will continue going up, they should buy a little bit shorter maturity than they have been: an eight- or nine-year bond instead of 10- or 12-year bond. That can make a big difference, up to 5 percent in price variation with an interest rate rise," Cummings says.

Another option for less volatility, premium coupon bonds will be less sensitive to interest rates than a par or discount bond.

"A premium coupon bond will fall less in price. It may be a difference of 3 percent or so," Cummings says.

A premium coupon bond trades above face value. Investors pay more for it upfront and get the face value at maturity. Premium coupon bonds typically have higher yields than similar bonds selling at par, or face value.

The math doesn't always work out. "Somewhere it makes sense, and somewhere it doesn’t," Cummings says.

For investors who know they will hold fixed-income investments through a rising-interest-rate environment, premium coupon bonds could add some stability through what promises to be a bumpy ride.

Are you nervous about your fixed-income investments?

Follow me on Twitter: @SheynaSteiner.

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Senior investing reporter Sheyna Steiner is a co-author of "Future Millionaires' Guidebook," an e-book written by Bankrate editors and reporters. It's available at all the major e-book retailers.

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