What Now for Bond Investors

Between taper talk, a government shutdown and the doggone debt ceiling, it’s been a topsy-turvy time for bond investors. Most suffered losses when the yield on ten-year Treasury bonds soared from 1.6% in May to nearly 3% in September, then fell back to 2.7% in early October (bond prices and yields move in opposite directions). Now, with Janet Yellen slated to take over as Federal Reserve chief in January, many market watchers expect little change in monetary policy until then.

The Fed shocked pundits in September by announcing that it wouldn’t trim its monthly $85 billion purchase of Treasuries and mortgage securities until the economy strengthened. That about-face on tapering gives bond investors a breather, at least for now. The ten-year Treasury yield is likely to creep up to 3% in early 2014, says Jennifer Vail, the fixed-income strategist for U.S. Bank Wealth Management. Short-term rates won’t move anytime soon; the Fed has said it will keep the federal funds rate near 0% until unemployment falls below 6.5%, which many believe won’t happen until 2015.

As the economy improves, the Fed will eventually dial back on its easy-money policies. So a key question for investors is where yields would be absent the Fed’s bond-buying. Based on the historical relationship between yields and growth in gross domestic product, as well as in changes in consumer prices, the ten-year Treasury should sit between 3% and 4.2%, says Sam Stovall, chief stock strategist at S&P Capital IQ. All this suggests that yields will rise over both the short term and the long term.

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What’s a bond investor to do? One tack is to invest in sectors that got hit hard when the taper talk began last summer, among them corporate bonds (both investment-grade, rated triple-B or higher, and junk bonds) and emerging-markets debt (see A Juiced-Up Junk Fund). Floating-rate bank-loan funds will protect your portfolio against higher interest rates, too, says Fran Rodilosso, a bond manager with Van Eck’s Market Vectors.