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TheStreet Open House

Bond Investors: Heed Warnings About Rise In Rates

By MARK JEWELL

BOSTON (AP) â¿¿ Super-low interest rates will eventually rise, and when they do, bond investors could be stuck with losses.

It's a warning that's been heard frequently in recent years. Often, it's coupled with a reminder of the huge amount of cash â¿¿ more than $1 trillion â¿¿ that bond mutual funds have attracted in the past five years.

Warnings about rising interest rates have become louder in 2013, partly due to a spike in rates during the first couple weeks of the year. Consider this one: The prospect of higher rates "is looming ever-closer" says Art Steinmetz, chief investment officer at OppenheimerFunds, who describes a rate increase as "a dust storm that we're going to run into one of these days."

Although Steinmetz isn't predicting when a sustained rise will occur, he expects many investors will be surprised at how quickly bond funds can begin posting losses, especially if they hold plenty of lower-yielding Treasurys. Initial signs of a steady rise in interest rates could lead bond investors to sell. That would cause yields to suddenly climb and prices to drop.

Plenty of renowned investors have incorrectly predicted rates would be much higher by now. Yet there are some troubling signs. The yield on the 10-year Treasury note climbed to 1.90 percent on Thursday. That's the highest in eight months, and up from 1.70 percent at the start of the year. Mortgage rates also ticked up this week.

Interest rates remain historically low, but even a small increase like this year's climb in Treasury yields can have a big impact on fund returns. In fact, five of the 14 taxable bond fund categories that Morningstar tracks are down this year, with losses of as much as 2 percent.

A mutual fund's returns will vary because the manager must continually reinvest as bonds mature. This year's small rise in Treasury yields means previously issued bonds, which pay a lower interest rate, are now worth less. A fund with too much invested in those older bonds can end up with losses. That's because a fund's return is a function of bond price changes as well as the yield, or interest payments, that bonds generate.

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