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Becalmed bond market is in need of steady wind

The Baltimore Sun

It's a confusing time for bond investors.

One day analysts are fretting over the possibility of more inflation, which, of course, could cause bond yields to climb and make investors regret the fact that they bought bonds now instead of waiting for higher-interest bonds later.

On other days, the pros are fretting about the opposite - that the economy could slow down and cause interest rates to drop. Then investors would be happy about having the foresight to have bought bonds before they started paying less interest.

Amid the indecisiveness, an inflation and interest-rate scare sent yields on 10-year Treasuries to the most tempting level investors have encountered since 2002. On June 12, they climbed to 5.29 percent - a significant move from 4.89 percent at the end of May, and certainly a treat compared with lows below 4 percent a few years ago.

But as investors worried that distressed subprime mortgage investments could infect more than a Bear Stearns hedge fund, and housing news remained gloomy, fear of an economic slowdown became a drag on bonds and yields dropped to 5.13 percent at the end of the week.

Clearly, there is no clarity. Investors cannot decide whether they should believe Bill Gross, chief investment officer of the respected PIMCO bond fund, who recently said he thinks he underestimated inflation and now believes yields on 10-year Treasuries could go to 6.5 percent over the next few years, or side with those fretting about an economic slowdown.

Predicting interest rates is never easy - not even for the most knowledgeable economists. And it's even more complex now in an era of globalization. Some argue that a growth spurt outside the United States can kindle inflation here and abroad, even if a slowdown in housing construction in the states causes people to lose jobs and hold onto their pocket change.

In the past, U.S. bonds would have responded primarily to the American economy. Now the world is more interwoven. If rates on foreign bonds climb, economists say the U.S. might be under pressure to raise rates on Treasuries to attract potential foreign investors.

Reading the tea leaves for bonds means peering through a murky worldwide brew.

So what's an investor to do?

First, watch for news on inflation, and realize that if inflation picks up and interest rates climb, the bonds you bought today could lose value. If you are an investor that buys safe Treasuries and CDs, and you hold them until they mature, you won't lose principal - or the money you invested.

But if you invest in bonds through a mutual fund, you could have a loss. It happened in May as yields were trending upward. The Vanguard Total Bond Market Index Fund - which mimics the full U.S. bond market - lost almost 1 percent. And foreign bonds in developed markets lost about 2 percent.

If your money will be invested for many years, you should come through a temporary loss. If you have shorter-term needs for your money, the loss could be more detrimental.

The riskiest of bonds now are high-yield bonds.

"They are junkier today than they were back in the 1990 recession," said James Floyd, an analyst at Leuthold Group LLC. About 20 percent of them are rated CCC or lower, compared with only 2 percent in 1990, because it has been so easy for companies - even weak ones - to borrow money.

Overall bond defaults are low now - at about 1.7 percent - but rising, said Floyd. "There seems to be complacency about junk-bond risk, but higher and higher amounts of leverage and lower-quality debt will eventually end badly."

Gail MarksJarvis writes for Tribune Media Services.

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