NEW YORK ( TheStreet) -- Investing in bonds has proven to be a home run for 30 years, but the bubble is primed to pop.
The BarCap U.S. Government Aggregate Treasury Index has had an average annual return of 8.5% over three decades. Bonds' gains accelerated during the Great Recession, performance that attracted inflows. In fact, since April of last year, new money flowing into bond funds has far outpaced that of equity funds.
Going back further, bonds have benefited from the tailwind of falling interest rates since the Reagan administration in the 1980s. With yields on the benchmark Treasury bond now near record lows -- around 2% -- any increase will spell losses for investors.
As soon as the Federal Reserve begins raising interest rates, even by a small amount, investors run the risk of losing money. Longer-dated bonds will fare the worst. For example, a study by United Capital shows that the price of a 30-year Treasury bond will fall by 20% given an increase of 1% in interest rates.Investors have taken advantage of improved bond returns by buying bond funds and ETFs. These are very different creatures. Bond mutual funds act more like stocks than bonds in that they don't have a maturity date or guarantee of a return of principal. Ron Weiner, CEO of RDM Financial, says the "share" price of the bond fund will fluctuate based on two things: the quality of bonds and interest rates. Rising interest rates will have a particularly negative impact on these funds because managers must continually trade bonds to keep the fund alive since the funds don't mature. Therefore, principals will decline, hurting returns. Not helping matters is that managers will buy lower-yielding issues as high-yielding bonds mature. Weiner explains that most of the returns in bond funds over the past few years have come from capital appreciation as prices went up on declining yields. A much smaller portion has been related to the return from interest rates. Protecting against interest rate risk will be important for investors going forward. It's important to understand that bonds aren't 100% risk-free and must also be actively managed. While certain bonds and bond funds are riskier asset classes to own today, there are ways you can invest in bonds and still achieve attractive returns. Working with a professional adviser to balance your portfolio of stocks, bonds and cash is recommended to get the right mix. Joe Duran, CEO of United Capital, says "whether this bull market in bonds continues for another decade or not, it will make no difference to the fact that it is mathematically impossible for your future returns to look like the past. Therefore, your future actions should be different from your past actions." -- Written by Lindsey Bell in New York. >To follow the writer on Twitter, go to Lindsey Bell.