Most analysts and economists believe the Federal Reserve Board is practically compelled to do something to help boost the economy when it meets later this month. If and when the Fed makes a move, it will likely have a negative impact on bond funds.

S&P analyst Michael Souers said whether the Fed decides to implement some version of a third quantitative easing program, QE3, or another measure dubbed “Operation Twist” --which would the Fed trading short-term securities for long-term securities -- reverberations will be felt on Wall Street and on Main Street.

Souers told On Wall Street that, either way, the result could be a sell-off of longer-term bonds by bond funds and investors which could have the effect of raising yields -- exactly what the Fed is hoping to avoid.

“If the Fed tries to buy longer-term bonds, the investment firms are likely to dump their own long-term bonds in favor of equities, which would push up yields, overwhelming anything the Fed does,” Souers said.

In fact, he said, that is exactly what happened following the earlier announcements of QE1 and QE2.

This, in turn, led to increased inflows to alternative investments and out of bonds. 

Souers notes that  between March 18, 2009 and the end of QE1 on March 31, 2010, commodities as a group rose 51.2%, the S&P 500 advanced 50.5%, gold rose 18.2% and TIPS bonds gained 6.4%. Meanwhile the dollar fell 4.6% and all U.S. Treasuries longer than three-year issues fell, with 10 year to 20-year issues shedding 4.8%.  

From the first that QE2 was on the horizon back on Aug. 27, 2010 until its conclusion on June 30, 2011, commodities rose another 31%, the S&P gained 26.1%, gold rose 21.2%, and TIPS bonds rose 6.3%, while the dollar fell 10.5% and 10-20-year Treasuries lost 2.7%.

Souers said that while “no one can predict for certain” that any new Fed effort to push down long-term bond yields would have the same impact as earlier efforts, it might be wise for investors to avoid certain funds that would be particularly negatively impacted by a rise in longer-term yields.

The three funds Souers warns against are the Eaton Vance Government Obligations Fund (ECGOX), the Highland Government Securities Fund, Class A (HGPAX) and the SunAmerica U.S. Government Securities Fund, Class C (NASBX).

Souers said the Eaton Vance fund, with an average duration of almost seven years, would be at risk of significantly underperforming peers if interest rates surge. 

The situation at the SunAmerica fund is not much better, with a duration of 6.87 years. Even the Highland fund, with a duration of six years, Souers said, presents significant risk.



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