Bonds Are Getting Riskier

Until the past 12 months, bond investors have done quite well, thanks to a 30-year decline in interest rates from the high teens to 1%-plus yields.

But in the past year, the situation has changed as yields have settled into a Fed-induced low range of returns. The Fed's very accommodative policy has basically pushed the bond market to its interest rate lows.

This has made it clear to us that while yields might hover within a narrow range, for the time being they have only one way to go: higher.

When, as during this past quarter, there have been "shots across the bow" in terms of movements higher in bond yields, bond investors have gotten a sneak peek of the impact on bond prices from rate increases. It is not a pretty picture, especially for the many bond investors who have invested in longer-term bonds. It is not unreasonable to expect double-digit declines in market value in the face of relatively modest rises in rates.

Remember that such declines would have nothing to do with the strength or safety of a bond but everything to do with its maturity length. All things being equal, the longer a bond's maturity, the greater the likely decline in value in a rising interest rate environment. For example, a 1% increase in the yield offered by a 10-year bond would likely result in a decline of 8.5% or more in principal, and on a 30-year bond, that same 1% increase would result in a decrease of 20% in principal.

Such a potential loss is exactly what most bond buyers thought they were avoiding by moving out of stocks and into bonds. But while rates are at such low levels, and arguably being artificially kept low by the Fed's current policies, the potential for jarring upward yield movements is increasingly significant.

The likely catalyst for higher rates is a return to economic normalcy. Although the Fed has kept rates unsustainably low in order to facilitate the U.S.' economic recovery with ample liquidity, the economy is lately returning to a sustainable growth mode, as housing has strengthened, businesses are feeling more optimistic, and labor markets are starting to perk up.

While it still might be a ways off, all of this will eventually embolden the Fed to ease off its current policy. We believe that the bond market will probably move well before the Fed does. So while we don't know when exactly rates will begin to move higher, we do have a high conviction that this directional change is a virtual certainty, and that it will occur sooner rather than later.

Accordingly, our advice is simple: Now is the time to move out of longer-term bonds. We would advise moving much shorter on the maturity spectrum. It simply isn't worth it, in our view, to take a likely risk of losing almost 9% of market value for the right to receive less than 1.8% interest per year for a decade in a 10-year Treasury. While short-term bonds will not pay much return, they will insulate you from the sting of upward yield movements.

Another possibility is to reallocate some funds to high-yielding, lower-volatility stocks. Note however, that this group has excelled over the past few years, so going forward, upside is more limited, and there is likely greater risk than there has been in the recent past.

Most importantly, we strongly believe that now is a time to be shortening bond maturities in order to take some real risk out of your bond portfolio.