Most investors know rising interest rates are bad for bonds. That has certainly been the case over the past 12 months. As the rate on the benchmark 10-year U.S. Treasury note climbed 1.4 percentage points, to 4.68%, the price dropped 10%. Now, the Federal Reserve is expected to announce the first of what's likely to be several hikes in short-term rates after its June 30 meeting. So long-term rates will continue to face upward pressure.
When will it be safe to get back into bonds? Many bond pros are studying past Fed tightening cycles, economic data such as unemployment and inflation, and even the financial futures markets for entry points. In the meantime, unless you want to risk large capital losses, stick with the shortest maturity instruments, accept what even after a few rate hikes will be historically low yields, and wait for buying opportunities in longer-term bonds -- namely Treasuries, municipals, and high-grade corporates. You might also want to follow these guidelines:
LEARN FROM HISTORY
In early 1994, the Fed shocked the markets with an unanticipated rate hike, the first of six that took short-term rates from 3% to 6% in a year. Many investors lost money because they bought bonds after each increase, thinking each time the Fed was done tightening. You might be tempted to go in too soon just because long-term rates have moved up in anticipation of Fed action. Don't do it. "Wait until the Fed is pretty well along into [raising short-term rates] before you buy [longer-term] bonds," says G. David MacEwen, chief investment officer of fixed income at American Century Investments. He advises sticking with short-term notes until the federal funds rate reaches 2.5%. That would represent three to six tightenings, depending on whether the Fed moves in quarter-point or half-point increments.
SET RATE TARGETS
Bond maven Raymond T. Dalio, president of Bridgewater Associates Inc., a Westport (Conn.) investment management firm, takes his cues from the previous 11 periods of rising interest rates over the past 50 years. Based on this history, he figures the federal funds rate will peak around 4.25% and the 10-year bond around 5.75% within six months of each other. That's when interest rates will be high enough to slow the economy and make bonds attractive again.
Dalio won't wait for those targets to begin purchasing bonds. "We'll start buying bit by bit when yields on the 10-year get close to 5.25%, and the economy shows signs of weakening," he says. One sign, he notes, would be a 0.2-point uptick in unemployment from the post-recession low, now 5.6%.
LOOK TO THE FUTURES
When will interest rates hit your target? See what the futures markets are saying. Daniel C. Dektar, chief investment officer of Smith Breeden Associates, is keeping an eye on the March, 2005, federal funds contract that trades at the Chicago Board of Trade. At a recent price of 97.20, that translates to a federal funds rate of 2.80% -- meaning the market expects the Fed to raise rates 1.80 points from its current 1% by early next year.
Or look at the Eurodollar contract at the Chicago Mercantile Exchange. The contract essentially reflects at what level the London interbank offered rate (LIBOR) will be at expiration. That short-term rate is a good proxy for fed funds. At the recent 96.53 price, the market anticipates 3.5% Eurodollar and federal funds rates in June, 2005. Dalio suggests buying when a one-year contract points to a 5% yield.
Of course, these entry points are just estimates. But they can help investors jump back into the bond market with an educated guess rather than blind luck.
By Toddi Gutner