How to Navigate the Bond Market in 2011

Treasury yields have recently moved higher, shaking up some investors.

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The outlook for the bond market in 2011 remains uncertain. Recently, treasury yields have moved upward, causing some investors to panic and forecasters to call for the end of the bond market's bull run. The big question: whether or not interest rates (and bond yields) will rise in the new year. That will depend on a number of factors, including the fate of the Federal Reserve's second round of quantitative easing and the direction of the U.S. economy, but experts don't agree on what that will mean for bond investors.

After some improvement in the economy late last year and the passage of the extension of the Bush-era tax cuts, many economists upped their GDP projections. They expect that sooner rather than later, inflation will take hold as growth picks up. Those conditions combined with concerns that the deficit is becoming unsustainable will drive rates higher next year, says Marilyn Cohen, author of the upcoming book Surviving the Bond Bear Market. "We're already seeing the bread crumbs lead us into what's going to happen in 2011, and that's higher interest rates, lower bond prices, and a better economy," she says.

[See 5 Investment Themes for 2011.]

On the other hand, the economy could continue to grow slowly, tempered by the stubbornly high unemployment rate and a still-weak housing market. Warren Pierson, senior portfolio manager with the Baird Funds, says there is no guarantee that rates will rise significantly next year. "A year ago people were thinking, 'Oh we're going to see the Fed have to raise rates in 2010.' And, well, they didn't." The 10-year treasury yielded 3.8 percent at the beginning of 2010—a half of a percentage point higher than it yielded at the end of the year. Pierson agrees that the national debt will be a concern heading into 2011, but he believes inflation will remain low because of the high unemployment rate. Ultimately, what drives interest rates is expectations for inflation, he says.

For investors who depend on the payouts from their fixed-income holdings, here are some suggestions from experts on how to weather the bond market in 2011:

Don't panic. Regardless of how they perform in the short term, "[bonds are] likely to provide decent returns over the long haul, and they're going to provide ballast to the portfolio," says Robert Tipp, chief investment strategist for Prudential Fixed Income. Recent losses in municipal and government bond funds have caused some investors to pull out. But despite some losses late in the year, most bond funds turned out solid (or at least positive) performance in 2010. Tipp cautions that investors shouldn't neglect the fixed-income portion of their portfolio.

Stay on the short end. Some investors have learned the hard way that if yields rise, it's possible to lose money in bond funds. For example, over the past three months, the average long-term government bond fund has lost 9 percent. The longer a bond's maturity, the more susceptible it is to interest-rate hikes. "If rates go up, all those prices are going to go down, so stick with [shorter maturities]," Cohen says. "I know you sacrifice yield, but you preserve capital." She recommends buying bonds or bond funds with maturities of eight years and shorter.

Look beyond treasuries. When interest rates rise, treasuries are hit the hardest. Other fixed-income sectors, such as corporate bonds and high-yield bonds, are less impacted by increasing rates. Corporations are holding historically high levels of cash, and their balance sheets have improved mightily since the depths of the downturn. Experts say that in the coming months, corporate bonds look much more attractive than treasuries. By investing in corporate bonds, investors get a higher yield and the chance for capital appreciation, says Christian Hviid, chief market strategist for Genworth Financial Asset Management.

[See Why You Should Invest in Corporate Debt.]

While our government debt may not look all that attractive, many countries in the world have their financial house in better order. "The fact that the Fed in the U.S. is on hold doesn't mean that there aren't opposing moves happening elsewhere in the world, which certainly opens up opportunities to seek out diversification beyond just U.S. borders," Hviid says. Countries like China and Australia have recently raised rates and offer investors higher yields than treasuries are currently offering.