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8 Things You Need to Know About Buying Bonds Now

Richard Satran

If the Federal Reserve is planning to stop buying bonds should you do the same? The answer that investment managers and risk advisers give is that individual investors should definitely start "tapering" too - if they haven't already.

Many already have dumped their bond funds. The Fed in mid-June confirmed plans to start cutting back on its $1 trillion a year in bond purchases as early this fall. TrimTabs Investment Research says bond fund redemptions had already reached a single-month record $61.7 billion worth with a week left in the month. TrimTabs says it's a "dramatic departure" of mutual fund faithfuls who have been pouring funds into bonds since the stock crash of 2008.

As the fund exodus accelerated, bond prices tumbled and yields rose, the debate became whether the market had overshot. And no doubt there are amazing fixed income trading opportunities after the panic selling that caused the benchmark 10-year U.S. bond yield to leap 67 percent, from its May low of 1.5 percent to 2.5 percent now.

But unless you are a bond trader, the long-term trend is clear. Rates will rise, and advisers say to ignore the day-to-day financial television chatter of bond market insiders and Fed officials doing damage control in the market.

[Read: 12 Surprising Facts About Boomer Retirement.]

"There will be more landmines ahead for income investors," says Anton Bayer of Up Capital Management, an investment and financial planning firm. "And as interest rates rise, the risk of credit problems will grow." He says this means investors should worry not only about the loss of yield, but also repayment problems.

What should investors consider as they make investment choices going forward. Here are tips from allocation experts:

1. Avoid long-term or intermediate fixed-income bonds. Fixed-rate bond prices lose value as higher-yielding securities flood the market. Once they decline during the Fed "tapering," which has not even started yet, they may not regain value for a long time.

2. Bond funds are more vulnerable to market swings than individual bonds. If you bought a bond to hold to maturity it will pay its yield then repay you at par value. For holders of bond funds, however, there is no such protection from market swings. Their value floats each day depending on the market prices of the fund's holdings, and that's what investors will get when they sell.

3. Debt of short-duration will hold up better than longer-dated. With their shorter maturities, these funds can to shake off the effects of rising rates and move on as the funds turn over their holdings. Bryn Mawr Trust Chief Investment Officer Ernie Cecilia cites funds like Vanguard Short-Term Investment Grade Fund and Pimco Low Duration Fund as solid options that will hold up relatively well.

4. Strategic allocation multi-sector bond funds might hold up better as well. These funds swap between longer and shorter maturities depending on market conditions and employ hedging and other strategies to limit the impact of rising rates. They could be better bets in a time of transition to higher rates, says Bayer of Up Capital.

5. Total return funds like Pimco Total Return Fund, run by Pimco founder and co-chief investment officer Bill Gross, tend to have more long-dated securities than other bond fund classes and are more susceptible to market swings. Gross's Pimco fund fell to the bottom of the pack over the past month when the bond market turned sharply lower. His fund was also slammed as bond prices turned higher two years ago. Bayer says total return funds whose strategy of maximizing returns may work well in stable times can have problems during market transitions.

[Read: The Bill Gross Effect: Here Are Times Market Guru Has Called It Wrong.]

6. High-yield and junk bonds, and the mutual funds that hold them, might outperform at some point soon in the cycle. They behave differently from other fixed income because their prices are affected much more by credit quality. Defaults decline in stronger economic times, which boosts their market price and total return. They fell sharply with the rest of the bond market. But it boosted yields from all-time lows of 5 percent to a more attractive average of more than 6.5 percent.

7. Emerging market debt correlates more closely to U.S. government debt than high yield. But its moves are sharper. Downturns are more vicious and its recoveries more rewarding. After notable recent weakness, investment managers say the sector could soon offer attractive yields with relatively safe credit quality.

8. Floating rate bank loan funds are reset on 30-, 60- and 90-day intervals, much like variable rate home mortgages, and follow short-term rates dictated by the Federal Reserve. The rates are lower than average now because investors have flooded into the market for their protection against rising rates. It may be early to buy floating rates, but when the Fed lets short-term rates rise, their yields will float higher.

[Read: In Search for Yield Interest Rises for Bank Loan Funds.]

Still, the floating rate sector illustrates a key point for investors to keep in mind. As interest rates rise, so does credit risk. Many of the issuers of the senior loans have low investment ratings. When today's ultra-low rates go away, marginal companies that have been getting by with the help of low rates could be pushed to the brink.

"There are a lot of moving parts in credit and interest rates now," says Aaron Izenstark, co-founder and chief investment officer of Iron Financial, an investment management and risk-based advisory firm. "In long-term, there will be significant changes. When the Fed removes $1 trillion a year from securities purchase that is a big adjustment."

Investors need to consider not only their direct holdings but holdings of funds they own. Target-date funds, for example, are invested in a broad range of assets and may hold large amounts of fixed income, some of which is matched to the funds' specified retirement dates. Many income funds also take credit risks to boost yield, Izenstark says. Many hold non-government mortgages securities, a sector that he sees as vulnerable to credit risk. He says it could be worthwhile to review the prospectuses for your funds to see what kinds income investing risks they are taking. Funds are required to list such vulnerabilities.

Given the outlook for rising rates and the debt market's broad exposure to risks, now is no time for long-term bond investing, investment managers say. For long-term positions, equities make more sense, especially those that pay dividends from strong cash flow. "I see more headwinds on horizon in fixed income," says Bryn Mawr's Cecilia. "I would be very cautious. This transition to higher interest rates could bring a lot of volatility that may continue for a while. It could be very messy. Equities are more favorable."

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