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Tuesday, June 4, 2013

The Worst Is Yet to Come

Paul Krugman, Laureate of the Sveriges Riksban...
Paul Krugman, Laureate of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2008 at a press conference at the Royal Swedish Academy of Sciences in Stockholm (Photo credit: Wikipedia)
By Investment U

Boca Raton, Jun.4, daily stocks .- The For months, I've forecasted that interest rates would rise and, consequently, bond prices would fall. Now it's happening...

In May, the Barclay's U.S. Aggregate Bond Index - one of the most widely watched benchmarks for the fixed-income market - fell 1.62%. But many investors fared far worse.

For instance, the $292.9 billion Pimco Total Return Fund, the world's largest bond fund, fell 2%. And many leveraged fixed-income funds got hammered.

Take the Nuveen Insured Municipal Opportunity Fund (NYSE: NIO), for instance. This leveraged tax-free bond fund is an excellent vehicle in a rising bond market. The majority of its holdings are AAA-rated and insured... yet this is the last sort of thing you want to hold in a bond market rout.
From a high of over $16 just four months ago, the fund has plunged to just over $14, a 13% drop. And that's just with a tiny jump in interest rates. Wait until rates start moving up in earnest.

That's when things will really get interesting.

"Expert" Opinions

The bond market reversal took many so-called experts by surprise. Bill Gross, the manager of the Pimco Total Return Fund, is still heavily invested in Treasurys, which are highly sensitive to rising rates.

Another pundit on the wrong side of the bond market is Nobel laureate and New York Times columnist Paul Krugman, who has made a career of atrocious calls. (You need only go back and read his books over the last two decades.)

If you need a reason to believe interest rates are headed higher, just listen to Krugman's smug assurance that it won't happen.

After all, this is the same man who believes a) the federal government is far too frugal (I'm not kidding) and b) demanded in 2009 that Uncle Sam nationalize the money-center banks. Not only was it unnecessary, his plan would have wiped out shareholders entirely.

Fed's Folly

So why should you expect interest rates to rise and bond markets to sell off further?

It's not because the dollar is weak. Indeed, the dollar is in an uptrend and rose 2.5% in the last month.

And it's not due to inflation. Wages are stagnant. Commodity prices are falling. And traditional inflation hedges like gold and Treasury Inflation-Protected Securities are dropping.

No, it's much simpler than that.

It's because Bernanke & Co. have been not only following a zero-interest-rate policy on the short end, but holding longer-term interest rates down with a massive bond buying program meant to stimulate the economy, revive the housing market and strengthen the banks.

The Fed has not said when it will end its quantitative easing program. But the market has gotten a whiff that it's a matter of time, which was enough to send fixed-income investors to the exits.

What should you do as an investor?

Reduce your investment-grade bond holdings to just 10% of your asset allocation. Stick with short-term, high-grade corporate bonds, low-cost, short-term fixed-income funds, and defined-maturity ETFs.

The 30+-year bull market in bonds is over. And the worst is yet to come....

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