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Fed Tapering Is No Big Deal and Here's Why

Stocks in this article: APU KMP WPZ AMJ VNQ SPG

NEW YORK (TheStreet) -- The majority consensus seems to be the Federal Reserve's tapering of its bond purchases, or quantitative easing, will be problematic for the stock and bond markets. I'm not so sure.

"...everything ends badly, otherwise it wouldn't end." -- Cocktail (1988)

Stocks finally displayed some real vulnerability on Monday -- though after January's weakness thus far I don't think too many investors were surprised. Wrong-footed, yes, but not surprised. We have been due, or overdue, for a stock market correction for quite some time. Money doesn't flow in one direction forever.

There is something meaningfully different today than one or even two years ago, and that is the rate on the 10-year Treasury. Two years ago we were at 1.85%; one year ago we were still at 1.85%. Today we are a full percent higher at 2.85%. Now that may not sound earth-shattering to you, but it most certainly is for pension funds and fixed income mutual funds.

For the past several years bonds of all shapes and sizes have been called as issuers -- from municipalities to corporations -- have taken advantage of what Fed Chairman Ben Bernanke has given them. That is an opportunity to reduce cost of capital, in some cases dramatically, at the expense of bond investors.

Many bonds have call features that allow the issuer the ability to refinance its debt. Naturally this happens when interest rates decline. Victims of this phenomenon are the bondholders whose bonds get called. They are paid in cash (not literally) and then must seek out opportunities to reinvest that are just as good as their old bond. Since rates have fallen, there aren't any; the investor will need to accept smaller interest payments and/or more credit risk.

Another option is to sit in cash and wait for rates to normalize a bit.

"Don't just sit there, do something!"

Over the past few years, pension funds and "balanced" mutual funds have watched their allocation to stocks bubble up to uncomfortable levels, partly because they have been the more attractive asset class and partly from organic growth. These funds have an interest in reducing their equity exposure and locking in gains, and what a great time to do it (at least in relative terms).

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