A question of when, not if, bond prices will fall

Hand pointing to trading numbers on trading screen

By almost any measure, the bull market that bonds have enjoyed over the past 30 years is pretty much over.

As interest rates start to rise sometime in the next few years, bond prices will undoubtedly fall.

How far, and how fast, they'll decline will mostly depend on how soon and how quickly the Federal Reserve allows interest rates to move up.

An oft-quoted rule of thumb says that for every percentage point interest rates go up, bond prices will fall by an amount equal to the bond's duration.

Let's say the Fed ultimately allows interest rates to rise 3 percentage points — not an unreasonable expectation given the extraordinarily low yields we're seeing today.

We should expect the market value of 5-year bonds to drop 15%, 10-year bonds to fall 30% and 20-year notes to decline a whopping 60%.

Rising rates will depress the prices of virtually all government and corporate bonds we own, driving down the balance of just about every 401(k) retirement plan, IRA and brokerage accounts.

"It's going to happen; it's just a matter of when," says Cathy Pareto, a certified financial planner at Pareto & Associates in Coral Gables, Fla. "The Fed can't keep these loose policies forever, or inflation will become a real threat. Bond prices will fall when rates start to rise."

Why do bond prices move in the opposite direction of interest rates?

Let's say you had a $1,000 bond for five years with a 4% interest rate paid every six months. Now, say interest rates on that type of investment rise to 5%.

If you wanted to sell this deal on the open market, you'd have to offer it at a discount to make the deal worthwhile.

That's because no buyer would want to buy a bond earning 4% when they can get one paying 5% at the same price.

The face value of the bond would have to be discounted so that it essentially yields the new market interest rate for the buyer.

That's why the market value of your bonds, the value reflected in the balance of your retirement plan and brokerage account, go up and down.

Mostly up, of course, as interest rates have more or less fallen over the past 30 years. (See the chart below that shows the long-term trend for 10-year Treasury bonds.)

But with interest rates at historic lows, they really have nowhere to go but up.

The Federal Reserve influences how much we make on our savings by setting the federal funds rate — the interest rate commercial banks pay to borrow money that other commercial banks have on deposit with the Fed.

That rate has been essentially zero since December 2008.

When the Fed does allow rates to go up, it typically does so in small increments, every month or two.

Throughout most of history, the Fed's rate-setting committee has increased the federal funds rate by a quarter or half point after one of its eight meetings each year.

During the late 1970s and '80s, there were a couple of times when it shocked the markets with interest rate hikes of more than 2%.

But such massive movements are unlikely to happen this time.

Sarah Bush, a senior analyst at Morningstar in Chicago, says most fund managers hold the belief that it will be a "couple of years" before rates start to rise.

The Fed last said that it would hold short-term rates near zero at least until the unemployment rate dropped to 6.5% or below.

As of April, the rate stood at 7.6%, and most economists don't believe it will hit the Fed's goal until at least 2015. Some say it could even be much longer.

This means that you have plenty of time to get ready.

While we know there are bearish days ahead for bonds, you shouldn't necessarily purge your portfolio of them.

Having a portfolio in 100% stocks could be very risky. Perhaps even more risky than losing some value in your bonds in the coming years.

Stocks are inherently more volatile than bonds, and bonds help give your portfolio a little stability. They can do that even at a time like this.

Bob Phillips, managing principal with Spectrum Management Group in Indianapolis, recommends staying with short-term bonds in the meantime.

You can still earn some yield and minimize your interest rate risks.

"As interest rates start moving up, longer-term bonds could become a disaster waiting to happen," Phillips says. "Many people not understanding why may just start wholesale moving out of bonds into equities or somewhere else."

He says the additional "opportunity costs" in long-term bonds are not worth the added interest rate risk.

If you're already in long-term bonds, he still recommends staying put for a while.

He recommends keeping an eye on the 10-year Treasury and says a pivotal moment will be when it reaches 2.35%.

"We think that will be an indicator that momentum for rising rates has begun and you'll want to become very cautious," Phillips says.

Like many investors and analysts, he watches the 10-year Treasury to gauge the bond market.

The long-term average of the 10-year Treasury is 6.61%. As of April, it was near 1.72%.

He says the Fed is essentially acting as a "backstop" against rising rates, but that will start to fall once the Fed slowly ends quantitative easing.

Others also watch mutual funds and ETFs because they have shorter durations.

The largest bond fund in the world, the PIMCO Total Return Fund (PTTRX), has an average maturity of 5.9 years.

In theory, the pricing trends of these funds may give you an overall gauge of where bond prices may be heading in general.

Aside from their interest rate risk, bonds also have a credit risk. This is the risk of the debtor not being able to pay back the money.

The federal government is the least risky, but it also has the lowest yield. The highest yields can be found in some foreign nations or corporate junk bonds.

Now that the capital appreciation days on bonds are coming to an end, the hope is that your yield may simply offset or reduce any coming loss in principal.

hand holding stack of money

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Pareto recommends avoiding long-term Treasuries and staying with short-term bonds. If you're willing to take on the risk, you can find even higher yields in emerging market bonds.

"You need to find the risk that is right for you. This underlines why it is important to build a portfolio that can withstand the test of time. You need to think long-term," she says.

The good news about rising interest rates is that this may also cause a rise in yields in other places, such as CDs or money market accounts.

That could give you an alternative to earn some yield in a safe manner.

Back in 2007 when you could earn almost 6% risk-free in a high-yield savings account, it was a great place to be.

Phillips says an unfortunate part of the Fed's actions is that savers are being pinched with nowhere to turn for a safe yield. In the near future, he believes the primary goal of bond investors will be mere capital preservation.

"At this stage of the game, we just have to think about protecting principal and taking a defensive position. It might mean moving money into cash or bond funds that won't pay much interest," he says.

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