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.

The bond's owner has an ugly choice: Sell at a loss or keep the bond until maturity to get the full face value, but get a below-market yield until then.

The problem is especially bad for people who use mutual funds for bond investments. Because funds own an assortment of bonds, and regularly replace them to maintain the average maturity promised to investors, the fund itself has no maturity date. So the investor can't just wait to get face value.

Over time, the fund will gradually replace its low-yield bonds with ones that are more generous, but investors can still lose money since the fund will sell many of its older bonds at a loss.

The whole process works the other way, too, with falling yields driving bond prices up. That's why bond investors have done so well during the past couple of decades. Now, however, bond prices are too low to fall much more, and improving economic conditions are likely to drive yields upward for some time.

This can be good news for stocks, as money fleeing bonds often moves into stocks, driving prices up through higher demand. But many fixed income investors, especially people in or near retirement, don't want to put everything into stocks because of the high risks.

The solution? For now, old-fashioned bank savings look best. They're not very generous with savings accounts yielding just 0.112%, and five-year CDs just 1.131%. But with bank savings, you are insured against loss - your principal is far safer than in a bond.

And bank savings are liquid. In a couple of years, bond yields may be considerably higher. If they show signs of topping out, investors will be able to buy bonds, earn more than they can today and face less risk of loss from a further rise in yields.

For now, given the improving economic signs, fixed-income investors are probably better off emphasizing safety and flexibility, waiting for a chance to pounce on higher yields later.

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