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Interest Rates Wiggle. Bond Investors Panic.

Take a look at this chart. It shows the monthly flows to bond mutual funds over the last two years. See if you can spot the outlier:

Source: ICI.

Suddenly, nobody wants bonds.

That's understandable. Interest rates are rising, and for the first time in years, bonds are losing money. The PIMCO Total Return Fund is down 5.6% since April. The Vanguard Long Term Corporate Bond ETF (NASDAQ: VCLT  ) is off nearly 10% in the last three months. The popular iShares Barclays 20 Year Treasury Bond ETF has lost more than 11% in the last 90 days.

But what's interesting -- maybe scary -- to think about is that the rise in interest rates over the last month isn't that large, historically. Interest rates on 10-year Treasury bonds have increased by about 60 basis points in the last month, according to data from the Federal Reserve. In percentage terms, that's a lot. But interest rates are so low right now that percentage gains can be deceptive -- a doubling of interest rates from last summer's lows would mean a gain of only a little more than one percentage point.

In absolute terms, the rise in interest rates over the last month isn't that impressive: 

Source: Federal Reserve, author's calculations.

If bond investors have panicked at what has been a pretty mild rise in interest rates, what will they do when rates really start to rise?

It won't be pretty. My guess is there will be a few more outliers on that first chart. 

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 09, 2013, at 5:22 PM, SkepikI wrote:

    "But what's interesting -- maybe scary -- to think about is that the rise in interest rates over the last month isn't that large,"

    Scary indeed Morgan. Thank you for writing this article destined to be consigned to obscurity and ignored by those who need it most. It saves me from my own nagging urge to write one.

    And if you readers think THAT'S scary, think about this: rates were so low and still are so low, the mild decline in prices have completely wiped out the interest earnings for the last 6 or 8 months! You Bond owners and fund investors are NOT being paid for the fearsome risks you are running from oppressed interest rates and artificially inflated bond prices.

    What ought to be stark terror of inevitable return to normalcy is significantly absent for Bond investors. Just consider this thought experiment: What happens to the price of your bond funds with duration near 10 (as many long term are like Vanguard) when interest rates adjust up by a mere 1%? Price down 10%...lost every bit of interest earned in the past, what 4 years? UGLY! (simulate panic here)

    And that's only a 1% change. How much do YOU think interest rates are depressed by?

  • Report this Comment On July 10, 2013, at 3:30 PM, StockGamingCom wrote:

    Bonds seem over-sold. However, in the long run, there's a higher probability that interest rates will go up than down. Therefore, one can play the bounce but the long term viability is a big question mark.

  • Report this Comment On July 10, 2013, at 10:53 PM, KKoleto wrote:

    I had always read to go with intermediate bond funds. Maybe that "set it and forget it" approach is a mistake. What I can't get past is when equities tanked a few years back I just stiffened my lip and waited it out, doing some shopping along the way.

    So why am I so nervous with these bond funds going South? Anyway, I am now looking at building a short bond ladder with the thought that rates will rise over time.

    Funny, my first mortgage in 1970 was for 7.9. I was told I'd never see rates that low again!

  • Report this Comment On July 12, 2013, at 11:36 AM, Grimsyke wrote:

    I'm new to making comments and perhaps I am in the group of people that the government feels do not understand basic finances but I read today that the government announced it is going to continue their economic stimulus for the next while and the news says the stock markets soared on this good news.

    According to my understanding, their "stimulus" is done by spending $85 Billion a month to buy their own debt issues and they are doing this with extra money that they are printing. That is a Trillion dollars a year and they have been doing this for a few years now. Maybe I'm wrong but that seems like a recipe for massive inflation and increases in interest rates if I ever saw one. This seems crystal clear to me.

    What I don't understand is why the media and experts are raving that this is a good thing and celebrating??

  • Report this Comment On July 13, 2013, at 8:20 PM, Zeppelin6880 wrote:

    If you've recently bought bonds (i.e. in the last year or so), yes you've taken a hit. If you've had bonds since 2007 like myself you are still up HUGE when taking into account capital gains due to decreasing interest rates. So a one month rise in interest rates does not concern me, and the Fool should know this best as they advocate for a long-term investing approach.

    Also, people have been saying for years rates have nowhere to go but up. They've been wrong. I still think the 1.4% or so the 10 yr Treasury hit will again be breached once Europe blows up this year or next (not literally, but financially, just in case the NSA is reading this). The European crisis is anything but over. Greece, Portugal, Italy, Spain, et al are just a precursor to what will occur when investors realize FRANCE is the real risk. Once that situation boils over again money will come across the Atlantic again driving down our rates here. You could see a 1% 10 yr Treasury, which 5 or 6 years ago would have been an impossible thought.

    Just a warning, but interest rates can stay low and remain there much longer than seems possible. Just look at Japan. Many a money manager's career has been ruined by betting on a rise in Japanese interest rates.

    Cash may be best right now, as the risk/reward ratio for both stocks and bonds seems bad. Stocks are priced at a premium when looking at Shiller P/E (CAPE, cyclically adjusted P/E). Once corporate profit margins revert to the mean (and they ALWAYS have), stocks will get hammered. When this will happen is anyone's guess, but you've been warned.

    Stay in short-term bond funds so you can re-invest at higher yields as they rise. Buy gold/silver (5-10% of your portfolio) as insurance.

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