Bonds have enjoyed a three-decade-long bull market, but the double-digit interest rates of 30 years ago are nearing zero today and have nowhere left to fall. The Federal Reserve has said it expects to keep interest rates low through mid-2015, but does that mean bonds will be a safe bet for another two years? Don't count on it.

While the Fedhas virtual control overshort-term interestrates, it has little control over intermediate- and long-term rates. In an effort to drive down long-term rates as well, the Fedinitiated Operation Twist, under which it sells short-term bonds and buys long-term bonds - but markets haven't cooperated. The 10-year Treasury bond rate actually rose to 2.43% from 1.88% in the five weeks following the announcement of the program in September 2011.

For further evidence, go back to March 2007. The economy was going strong and the Fed had inflation fears. To slow the economy, the Fed pushed up the fed funds rate, forcing short-term interest rates up. Markets didn't take the bait, and the typically positive sloping yield curve turned negative. It turns out the markets were right, as inflation didn't raise its ugly head.

 

UNCERTAIN FUTURE

While it appears likely the Fed will keep the overnight rate near zero for a while, what will happen to intermediate- and long-term rates? The mean forecast of 46 economists surveyed by The Wall Street Journal is that the 10-year Treasury note will rise to 2.26% by December from its recent level of 1.75%. That's a significant increase that, if it happens, would cause longer-term bonds to turn in a significant loss.

But how certain are these economists? Not very. While on average they predicted a 2.26% rate, the variance ranged from a low of 1.5% to a high of 4.34%.

Even their average forecast has a dismal record. According to Bianco Research, these esteemed economists have, as a whole, predicted the direction of long-term rates correctlyless than half the time. In other words, they have been less accurate than a coin flip.

Before reading a lot of bond market research, I felt uniquely qualified to forecast interest rates in the wrong direction. But it turns out I'm just another face in the crowd.

Oddly enough, the top economists' dismal track record doesn't seem to affect their confidence. John Silvia, the chief economist for Wells Fargo and one of the economists regularly surveyed by TheJournal, declared on May 5, 2011, that rates would definitely go up for the rest of that year.

In actuality, the five- and 10-year Treasury rates both plummeted far more than one percentage point from an already historic low level.

 

GUIDING CLIENTS

In helping our clients understand investing in bonds, there are three conclusions planners can make:

*We can't simply assume that intermediate and long-term interest rates will remain low for another two to three years.

*We also can't assumethat the bond bears will finally be right.

*Perhaps most important, we can be absolutely sure bonds won't have the stellar returns of the last five to 10 years.

I call my third conclusion the Bond Party Is Over prediction. It may sound like a bit of hypocrisy on my part since I have just recited the dismal record of those who make predictions about bonds. But the Bond Party Is Over prediction is based on some math and logic.

The Vanguard Total Bond Fund (VBMFX), which aims to replicate the Barclays Aggregate Bond Index, gained an average of 6.47% annually over the five years ended Sept. 30, 2012, according to Morningstar. It would take continuing declining rates to produce a return anywhere near its five-year average return, but the fund's yield recently was just 1.6%.

 

SIMPLE MATH

Given the fund's duration of 5.1 years and using some simple math, a 6.47% return over the coming year would put interest rates very close to zero.

Thus, the bond party can't go on for much more than another year, unless we enter a negative rate environment. I'm betting no one will lend $100 with the promise of getting back $99 in one year (although this has begun to happen in some of the stronger European countries using the euro).

It may seem more than obvious that bonds can't deliver the handsome returns of the 30-year bond party for much longer.Yet many forecasts, including those using sophisticated Monte Carlo simulations, still assume bonds will return their historic average of 5.41% for the 10-year Treasury.

Other models blindly use Ibbotson historical data, even though Roger Ibbotson states that "given the current low-yield environment, it would be almost impossible for bonds to generate the same amount of capital gains as they did in the past." This means that the likely return from bonds will be coming from yields, as the room for capital gains shrinks.

 

IF RATES RISE

It's hard to tell whether rising rates would be good for the economy. If rates rise because the economy is improving, that's good news for everyone, says author and financial theorist William Bernstein. He says it could even be good news for the housing recovery, because banks would be willing to lend again.

But if the credit markets lose faith in U.S. fiscal policy or the Fed botches the unwinding of the quantitative easing programs, Bernstein notes, that's bad news for everybody.

Even if it's difficult to predict what would happen to the economy if rates rise, the impact on bond investors is pretty clear.

Each one-percentage-point increase in rates would cause a bond or bond fund to decline by 1% multiplied by the duration - the geometric average of the interest and principal repayment.

For example, a single percentage point rate increase would cause the Vanguard Total Bond Fund, with a 5.1-year duration, to decline by an estimated 5.1%.That's a fair amount of risk, considering the yield is only about 1.6%.

Longer-term bonds could really get creamed. The PIMCO Long-Term U.S. Government Fund (PFGAX), which has a 16.3-year duration, could lose 16.3% with only a percentage point increase in long-term rates.

Jason Zweig, a columnist at TheJournal, has said he was particularly worried about closed-end bond funds. These funds often use leverage and tradefrequently at large premiums. Zweig says that they would suffer if the short end of the curve rises. He also notes they're hugely popular - an enormous asset class among people who don't read fine print. Indeed, these instruments were among the worst-performing bond funds during the 2008 financial crisis.

 

ALTERNATIVES TO BONDS

It seems as if clients are caught between a rock and a hard place. On one hand, they can get protection against defaults and rising rates, but must settle for a one-year T-bill rate of 0.17%, far below inflation. On the other hand, they can reach for yield by taking on more risk.

Many market experts have recently recommended this, such as economist Burton Malkiel, best noted for his book, A Random Walk Down Wall Street, who advocated closed-end bond funds and dividend-paying stocks in place of bonds.

At my firm, I personally favor long-term certificates of deposit that have easy earlywithdrawal penalties. By staying under the FDIC or National Credit Union Association insurance limits, one can eliminate default risk. It's easy for a couple to get $1.5 million insurance or more at each institution by titling accounts correctly.

An easy earlywithdrawal penalty acts as a put option, forcing the financial institution to buy back the CD at a small discount.For example, if cashed in after one year, an Ally Bank five-year CD paying 1.61%, which carries a 60-day early withdrawal penalty, yields 1.35% after paying the penalty. (See Effective Payoff chart below.) That may not sound like much, but it's nine times the yield of the one-year T-bill.

Amid all the evidence I've tried to lay out, don't take it as a prediction that rates will rise over the next year or two. I've long ago learned that my crystal ball for intermediate- and long-term rates is broken.

But at the same time, don't assume the Fed can keep anything other than short-term rates low through 2015. Advisors should educate clients that, like the top economists, we don't know what will happen to rates in the next year.

And advisors should never forget that the role of the fixed-income portion of client portfolios is to act as a shock absorber when stocks have their next plunge.

 

 

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct faculty member at the University of Denver.