It would be an understatement to say retail investors have felt more comfortable as lenders since the end of 2008. They have moved in droves toward fixed income, buying up any and all sectors that were available. As with the shift out of equity investments, the move toward bonds was heavily influenced by the fear and panic that came with the near collapse of the global financial markets.

Investors injected roughly $385 billion net into taxable bond products in 2009 alone. Add in the net sales of municipal debt products, and total inflows for all bond mutual funds and exchange-traded funds ballooned to nearly $470 billion in one year.

While this initial shift was understandable—fund investors were reluctant to put their trust back in stocks—what couldn't be predicted was how long the risk aversion would last. The unfettered interest in fixed income has persisted over the past several years despite the reality that rates eventually will rise. Fixed-income products continued to be the main draw for asset managers through 2012, even as the equity markets were able to recover nearly all of their recession losses by then.

Other than displaying a general aversion to equities, the shift toward bonds was also fueled by continual decreases in yields and increases in bond prices. Why would investors go back to what was perceived as higher risk in stocks when bonds were outperforming?

Investors felt comfortable with the annualized performance of nearly 7% for the average core bond product over the past three years. If that return was not enough, one could find stronger prospects on either end of the fixed-income risk spectrum. High-yield products returned nearly 10.5% on average during that period, while general U.S. Treasury funds were not far behind at 9.8% annually. (The average annualized return for U.S. diversified equity funds was 9.2% annually over that period.)

Watch for a Lethal Shock
With over $1 trillion of net inflows to bond mutual funds and ETFs since the end of 2007, and no signs of a slowdown regardless of pricing, many believe a sudden shift in yields may deliver a lethal shock to retail investors—just like equities experienced a little more than four years ago. The real question is when and how fast?

With the Federal Reserve continuing to support a low-rate environment, many investors think the yield shift will not happen soon. Despite continued improvements in the U.S. economy and unemployment, the targets of 6.5% unemployment and a greater-than 2.5% inflation rate seem to be far off. Some observers, such as DoubleLine Total Return Fund manager Jeffrey Gundlach, believe we will continue to see yields decrease in the short term. Gundlach predicted in a March conference call a yield of 1.63% for 10-year Treasuries by the end of 2013, sharply lower than the 1.87% yield at the end of March.

Besides trying to time when interest rates will rise—a challenging endeavor in itself—investors need to consider how a rate increase may play out. We've seen two general scenarios mentioned recently: a steady increase associated with economic recovery, or a spike in rates over a short period. The effects of each of these scenarios can be seen in historical average returns for funds within Lipper's Intermediate Investment-Grade Debt Funds category. This group contains the most assets under management for fixed income funds, roughly $840 billion as of year-end 2012, and includes familiar names such as PIMCO Total Return Fund and Vanguard Total Bond Market Index Fund. We also use the 10-year Treasury rate as a proxy for interest rate movements.

Many think the first scenario of a steady increase in rates associated with economic recovery would be the most likely situation ahead for the United States. The most recent example of such a move began on June 13, 2003, as equity markets began to rebound from the tech-bubble burst. From that point, the 10-year Treasury rate rose from 3.1% to 5.3% on June 12, 2007. During that period, Intermediate Investment-Grade Debt Funds returned 2.1% on an annualized basis. While it wasn't spectacular, bond fund managers had enough time to position their portfolios during the period to limit any losses based on increasing yields.

Calculating Future Risk
The second scenario of rapidly increasing rates is often associated with the risk of quick increases in inflation, but that has not always been the case. In fact, in recent periods of aggressive rate increases by the Fed, the catalyst was not a reaction to rising inflation but an accurate analysis of its future risk.

In 1993 to 1994, 10-year Treasuries increased from 5.2% on Dec. 15, 1993, to 8.1% on Nov. 7, 1994—a rise of 2.9% in just 327 days. This move was not a reaction to an increase in inflation—inflation was actually dropping. Instead, it was due to the Fed's foresight of future price pressures in the economy, since the economy was growing at more than a 5% rate at the end of 1993.

That growth prompted the Fed to increase the Fed fund rate two percentage points over the period. Regardless of the reason for the rapid rise in interest rates, the effect on bond fund investors was the same. Over that 327-day period, the average Intermediate Investment-Grade Debt fund lost 5.2%. While not close to the losses we saw for equities in 2008, the 1993-1994 scenario revealed the vulnerability of fixed-income funds to sizeable losses. Predictably, investors who had extended their portfolios into higher-yielding and longer-duration products suffered worse.

It's important for investors to understand the level of interest-rate risk they carry in their portfolio. Funds with higher durations carry more interest-rate risk than those with lower durations.

With the increased concerns over the effects of rising interest rates, it's important for investors to understand what type of risks they're carrying. Many fund managers use a series of interest-rate swaps to dampen these risks by lowering overall portfolio duration. Other specific bond strategies may also be useful in mitigating risks, such as floating-rate funds or short investment-grade debt products.

Given that the risks Bernanke's Fed faces are vastly different than the ones Greenspan faced nearly 20 years ago (concerns about the U.S. economy overheating haven't been heard in years), the path that today's Fed will employ to combat signs of inflation will likely be different as well. To the extent we can rely on history to be our guide, it has not been the gradual rise in rates that hurts investors; it's the spikes. With today's Fed actively forcing rates down at the lower end of the yield curve, investors ought to be vigilant for signs that the Fed may be extricating itself from the bond markets. That may be today's version of a rate hike.

Matthew Lemieux is a senior research analyst for Lipper. He specializes in performance analysis, methodology management, and fund flows and also contributes to Lipper FundFlows Insight Reports.

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