How to Best Avoid a Loss in a Slow-Motion Bond Market Meltdown

The bond market remains at risk of a correction as the economy continues to heat up in late 2013.

A "bubble" typically implies a market condition that is ready to burst at anytime.

We've all heard about the bond "bubble," while the Treasuries look more expensive in particular. There isn't anywhere for yields to go but up when the benchmark 10-year note pays out below 2% yield.

The United States (US) economy is starting to improve gradually, even though on the slow side. Rather than a bubble doing a quick deflate, one should visualize a block of ice melting down gradually. Even though growth is usually positive for stocks, for bondholders it is commonly seen as hazardous.

If the Fed allowed interest rates to rise it would probably attract investors from the perceived safety of bonds to invest their funds into opportunities with more risk. This could only happen with a stronger economy. The market itself presented a glimpse of just that already: As of the summer of 2012, the yield on 10-year Treasuries advanced from 1.4% to 1.9%, while simultaneously long-term government bonds then lost nearly 9%.

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Treasuries are typically the most exposed to rate shifts resulting from razor-thin yields. The remainder of your portfolio losses might also suffer from these adjustments. One can minimize the pain without entirely giving up on yield with the appropriate strategy for each type of bond owned.

The risk: Which way treasury returns are headed is still a hazy image in the crystal ball sitting on the desk of each economist. The current 10-year yield is presumed to be the most reliable predictor of returns in the near future on government bonds, claims Doug Ramsey, investment officer on the desk at the Leuthold Group. Currently stuck at a sub-2% yield, "you're in store for a very long period of disappointing results," Mr. Ramsey postulates.

And that's still before inflation is figured in.

Even as consumer prices creep upward, they have thus far been reasonably mild in 2013. James Swanson, chief investment strategist for MFS states: "Pressure tends to build only after unemployment sinks below 7% and factory capacity tops 80%."

The economy appears most apt to test those thresholds before the end of 2013. Investors could suffer losses with even a minimal 2.5% inflation rate.

What to do: Shorten up on investments: Dangers still lurk in global economies as well as the United States. However slight returns might be, there's still reason to hold a minimal position in Treasuries. Bonds having longer maturities are considered more risky now.

CORPORATES

What's the risk? The difference between Treasuries and high-quality corporate yields collapsed in late 2011 from about three percentage points to barely 1.3 points, nearly a record low point.

"Corporate bonds are now exposed to higher interest rate risk," Carl Kaufman stated, this from the fund manager for the Osterweis Strategic Income Fund.

Credit risk has been reduced as the economy grows stronger. Risk equates as the possibility for a company not making its coupon payments. Companies have added more debt onto their balance sheets as they grow more confident from a robust economy. For absorbing added credit risk of lending to a private company instead of Uncle Sam, today's low yields mean you aren't getting much as a reward.

What to do: First, diversify your bets . Reducing credit risk by holding the debt of various companies by purchasing shares in a mutual fund instead of an individual bond is how some investors diversify.

Understanding different bond funds

Limiting any ability to manage interest rate risk is the main problem to this approach. That one can plan to hold bonds until they mature and pay off their full value is the primary reason to purchase individual bonds. Day-to-day price swings brought about by rate changes are generally ignored this way.

One can combine the advantages of a fund and individual bonds by employing a newer type of exchange-traded fund (ETF) . An ETF invests in similarly dated bonds and keeps them until maturity, at which time you are reimbursed your investment amount.

HIGHER-YIELD

The risk: A junk bond's average yield – a bond with a stronger chance to default which gives investors a bigger than average payout is nearly 5.8%. So a noticeable uptick in interest rates is not the primary worry.

Anthony Valeri, a strategist for LPL Financial says "The bigger threat is deteriorating credit."

What to do: Strengthen your bond credit quality . Stay in a fund that keeps about 80% invested in bonds with a B, BB, or higher rating. With an average yield of 4.8%, Fidelity High Income (SPHIX) complys and has outperformed similar funds over the past five years.

MUNICIPAL BONDS

The risk: As the economy improved, tax receipts for state governments increased for the last 11 consecutive quarters. Therefore, credit risk is less with municipals as opposed to three years ago.

What that translates to is interest rate risk has risen while yields have fallen. The actual yield for a high-quality 10-year muni (if purchaser is in 28% bracket) is now down to nearly 2.6%, after accounting for the tax breaks municipal bondholders enjoy. At such low rates and high prices, "munis will move more in lockstep with Treasuries than they have in recent years," says LPL's Mr. Valeri.

What to do: It's best to reduce the stake from five to 10 percentage points. "There are other opportunities in the taxable market that give you similar types of after-tax returns with less interest rate risk," says Jack Chee, the senior analyst at Litman Gregory Asset Management.

In example, Mr. Chee refers to Kaufman's Osterweis Strategic Income (OSTIX) fund, which stays invested in various bond types. A decent amount of high-yield debt is in the fund, but with a current holding time of only 2.7 years, Kaufman's fund does not have much interest rate risk ,.

When the Federal Reserve eventually turns up the burner, the above strategy may help keep investors cool.

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Source by Josh Holliday

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