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How to Invest on Rising Bond Yields

NEW YORK ( MainStreet) -- Good news for some is bad for others. And when worries rise, cash is king.

That's the takeaway from the Federal Reserve's mildly upbeat comments Tuesday about the health of the U.S. economy. While growth is good, it could be costly to investors with money tied up in low-yielding bonds, including those near or in retirement.
Good news for the U.S. economy may make long-term bonds harder to dump.

By early Thursday, some bond yields had started to inch up. The yield on the 10-year U.S. Treasury note, while still a low 2.27%, was hitting highs investors hadn't seen since November.

Of course, fixed-income investors have been desperate for higher yields. But rising yields are a double-edged sword due to the inverse relationship between yields and bond prices. As yields on new bonds go up, prices of older, stingier bonds fall.

Many factors determine just how much they fall, but the principle is simple. Imagine you paid $1,000 for a bond yielding 2%, or $20 a year. If a new $1,000 bond paid 4%, no one would give you $1,000 for your old one. In a worst case, you might get only $500 for it. At that price, the yearly earnings of $20 would equal a 4% yield, the same as an investor could get on a new bond.

In real life the damage isn't usually that great, but a 1 percentage point rise in prevailing yields can easily drive a bond's price down by 10%, wiping out years of interest earnings. The longer the bond has to mature, the greater the damage, since its owner would be saddled with a below-market yield for longer.
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