Tags: ticking | time | bomb | bonds

WSJ: Fed’s Low-Rate Tactics Create Ticking Time Bomb for Investors

Tuesday, 29 Jan 2013 11:02 AM

By Michael Kling

By keeping interest rates super low, the Federal Reserve and other central banks around the world may have created a ticking time bomb for bond investors.

Rock-bottom interest rates have fueled the economic recovery, allowed homeowners to refinance at lower rates and boosted bond investors’ profits.

But many retail investors don't fully understand the loses they would suffer if, or when, interest rates rise and send bond values down, according to The Wall Street Journal.

Editor's Note: I Wish I Were Wrong — Economist Laments Being Right. See Interview.

Losses could be greater than in past periods of rising rates because of the huge amounts squirreled away in bond funds. Investors put over $1 trillion into global bond funds, and pulled $9 billion out of equity funds over the last two years, The Journal reports, citing JPMorgan Chase.

Values of long-term bonds like 10-year Treasurys are especially sensitive to rising rates. That's because payments from low-yield, long-term bonds are due in a lump sum years away, making the value of the bond sensitive to interest rate assumptions. A 1 percentage point increase in yields would equal a drop in price of nearly 9 percentage points for the 10-year Treasury, The Journal calculates.

If yields for the 10-year Treasury, which had a yield of 1.97 percent early Tuesday, returned to a more typical yield of about 4 percent, its value would drop by over 16 percent.

Of course, investors would get their money back if they waited 10 years, but they would be stuck with low yields.

Corporate bond investors also face substantial risk, according to The Journal. The average U.S. junk bond fund has a yield of 5.6 percent. Although the yield is higher than that for government debt, the market is less liquid.

If rates rise and investors flee, bond funds could be forced to sell, which could create an adverse feedback loop, The Journal warns.

Losses could come quickly. The Bank of England sustained mark-to-market losses of about $11 billion in the first 10 days of January when rates rose, The Journal reports, citing Bank of America-Merrill Lynch.

"Lack of awareness of interest rate risk causes many investors to severely underestimate their total portfolio risk," warns David Waring, co-founder of the bond education website Learn Bonds.

For instance, investors holding government bonds may think the bonds are safe, but their safety refers to their credit risk, not interest rate risk, he notes.

While rising rates prompt bond values to fall, bond fund values respond differently, he says. To determine a fund's interest rate risk, investors should check its duration.

A duration of five means that a 1 percent increase in rates would cause a 5 percent drop in the fund's value, all else being equal. A duration of two means a 1 percent rise in rates would result the value falling 2 percent.

Editor's Note: I Wish I Were Wrong — Economist Laments Being Right. See Interview.

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