Get Ready for (Somewhat) Higher Rates


For years, professional investors have been calling for a reversal of the long bull market in bonds. For years, they've been absolutely, positively wrong.

Now, though, after hitting multidecade low yields, the bond market has made a big turnaround, and rates on long-term bonds have moved up dramatically in just a short time. Is this just another head-fake that will eventually reverse itself and allow rates to go even lower, or is the long-awaited bear market in bonds finally beginning?

What we've seen
At the end of July, rates on government bonds dove to new lows, with the 10-year Treasury falling to just 1.4%. At that rate, the 10-year's yield represented less than 70% of the dividend yield on the S&P 500 and barely half the yield of the Dow Jones Industrials (INDEX: ^DJI) . Similarly, the 30-year Treasury dropped below 2.5%.

But in just three short weeks, rates have made a major reversal. The 10-year's yield has jumped all the way to 1.84% as of yesterday, while the 30-year now yields nearly 3%. Such wide swings are far from commonplace, and especially given how many investors have flocked to bonds for safety regardless of price or yield, it's essential to understand the risk involved in investing in bonds right now.

Bond ETFs can give you a read on the true impact of rising yields on bond prices. The iShares Barclays 20+ Year Treasury ETF has lost 8.5% of its value during those three weeks. The ProShares Ultra 20+ Year Treasury ETF, a leveraged ETF on long-term Treasuries, has dropped more than 16% in that time period. Even shorter-term bond funds have made some dramatic moves downward.

Immune from the move
Interestingly, though, the move thus far has largely been restricted to the Treasury market. Corporate bonds, both investment grade and high-yield, have seen some modest declines, but nothing like what the Treasury market has had to endure. The same holds for municipal bonds, which have seen huge inflows as investors become increasingly interested in protecting themselves from the adverse impact of taxes on their interest income.

If you take a longer-term view, though, none of this is particularly surprising. That's because Treasury bonds had stronger gains than most other types of bonds during their bull market run, so it only makes sense that the higher they went, the harder they'd fall.

When you look at relative value, some types of bonds stand out. Munis, for example, still yield more than Treasuries of comparable maturities in most cases, despite their tax advantages. But corporate bond spreads have narrowed to their tightest levels all year, prompting Kinder Morgan Energy Partners (NYS: KMP) , Leggett & Platt (NYS: LEG) , and PepsiCo (NYS: PEP) to take advantage of the low rates by issuing bonds in the past week. Even bond-rating agency Moody's (NYS: MCO) stepped off the sidelines and sold $500 million of its own debt earlier this week.

What's next?
Because the Federal Reserve uses the Treasury bond market as a major vehicle for policy change, especially since the advent of quantitative easing and Operation Twist, Treasuries operate in their own market niche. The key, though, will be to look at what rates in other parts of the bond market do. If they start following suit and heading higher, then it's likely that we will have seen at least a short-term bottom in interest rates.

That in turn should prompt you to start taking action to take advantage of low interest rates while they last. If you've been waiting to refinance a mortgage or other debt, for instance, you may not want to wait any longer.

Finally, low rates have been partially responsible for pushing the stock market up, as income investors have had few viable bond-market alternatives. It'll take a while for bond rates rise to attractive levels again, but if they do, then it could create an obstacle for stocks to move higher.

Even if rising bond rates create headwinds for stocks, the best companies can get you moving in the right direction. We've found three hidden treasures, and we're naming names in our latest special report: "3 Middle-Class Millionaire-Maker Stocks." It's free and waiting for you.

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Fool contributor Dan Caplinger has been ready for higher rates for far too long. He doesn't own shares of the companies mentioned in this article, although he does own municipal and corporate bonds. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of PepsiCo. Motley Fool newsletter services have recommended buying shares of PepsiCo and Moody's. Motley Fool newsletter services have also recommended creating a diagonal call position in PepsiCo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy will get you higher.

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