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Finding a soft landing when bond prices fall

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[July 01, 2014] By John Wasik

CHICAGO (Reuters) - (The opinions expressed here are those of the author, a columnist for Reuters.)

Contemplating the end of a 30-year bull run in bond prices is a bit like waiting to go to the dentist for some long-needed procedure. You know it needs to happen, but you procrastinate.

The end of the bond rally has been telegraphed for more than a year, so it needn't be painful if you prepare for it now.

Some of the conventional wisdom on avoiding all bonds except for short-maturity issues may be flawed. There are alternatives that can make sense while producing modest yield.

If you want to sacrifice yield now for protection later, consider a floating-rate bond fund that invests in securities with variable interest rates. Here are two funds to think about:

* The SPDR Barclays Capital Investment Grade Floating Rate ETF, for example, has little risk of losing money when rates rise. It gained nearly 1 percent last year as the Barclays U.S. Aggregate Bond Total Return Index a benchmark for the lion's share of the U.S. bond market lost 0.2 percent. It charges 0.15 percent for annual management expenses.

The sacrifice part is the short-term return: the SPDR fund is up only 0.14 percent for the 12 months through June 27, compared with more than 4 percent for the Barclays Index.

* The iShares Core US Aggregate Bond ETF, which tracks the Barclays index with moderate risk, is up 4.3 percent for the 12 months through June 27. It charges 0.08 percent a year in expenses. I hold it in my 401(k) as a proxy for the American bond market.

This fund would give you more yield than the SPDR fund and broader exposure to the wider U.S. bond market.

BE WARY OF THE YIELD CURVE

What about the traditional advice in a rising-rate environment - in which most bond prices fall - to go to bonds with short maturities?

Keep in mind that you face loss of yield and some volatility if you switch from bonds with maturities from five to 10 years to bonds that mature in under five years.

"The short end of the yield curve may not be a safe haven in the years ahead," says Joel Dickson, a senior investment strategist in the Vanguard Investment Strategy Group in Malvern, Pennsylvania.

There also may be some shocks in store in long-maturity bonds as the Federal Reserve retreats from its bond-buying stimulus program later this year.

Danger also lies in short rates rising rapidly, according to John Blank, chief equity strategist for Zacks Investments in Chicago. "Once they start rising, long-term interest rates can shoot up from their place between a range from 2.5 percent to 3 percent to close to 4 percent all in a few weeks. That is enough to shock fixed income markets and change the dynamics of global asset allocation dramatically," he wrote in a recent commentary.
 

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WHAT NOT TO DO

One of the worst tactics is to look at returns from past years in bond funds and expect them to continue or to think that traditional bond funds are safe havens. Past returns provide no protection against future interest-rate hikes.

Last year's hiccup in the bond market proved that even the most well-known funds are prone to losses. The A shares of the Pimco Total Return fund, one of the largest bond funds in the world, lost 2.3 percent last year. It's up about 4.5 percent for the 12 months through June 27. Longer-term, though, the fund has handily beaten the U.S. bond market's main benchmark over the past three-, five- 10- and 15-year periods.

But can you expect the Pimco fund, managed by embattled management legend Bill Gross, to live up to high expectations based on past returns? Thousands of investors don't think so, as the $229 billion fund has had some $50 billion in redemptions in the past year. The fund charges 0.85 percent for annual expenses in addition to a 3.75-percent sales charge.

Noting investor dissatisfaction two weeks ago at the Morningstar conference in Chicago, Gross sardonically called himself a "70-year-old Justin Bieber," referring to the troubled pop star. Gross said the "new neutral" environment will depend upon what happens when the Federal Reserve stops buying Treasury bonds in November. "The bond market has feasted on Fed buying," Gross noted.

At the very least, investors should fine-tune their portfolio's exposure to bond-market risk. Every bond fund has a "duration" measure that will tell you how much the fund will decline if interest rates rise one percentage point. The Pimco fund's duration, for example is around 5 percent.
 


Also keep a close eye on expense risk. It makes little sense to pay a sales charge for a bond fund or tolerate high expenses. That's why exchange-traded bond index funds are the best deals. High expenses eat into total return, which is low to begin with. You will have even more risk of losing money if you're trading bonds and don't hold them to maturity or hold interest-rate sensitive securities like real estate investment trusts or preferred stocks.

(Follow us @ReutersMoney or at http://www.reuters.com/finance/personal-finance; Editing by Beth Pinsker and Dan Grebler)

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