This time, a rate rise may be for real

Like the boy who cried wolf, many financial advisers long have warned about an imminent run-up in interest rates, only to watch in disbelief as rates sank further.

But after a crushing sell-off in bonds this month, the wolf actually may be at the door.

A number of analysts contend that an important shift in market sentiment occurred after the Federal Reserve's Federal Open Market Committee meeting March 13, where the FOMC made positive comments about the economic outlook. That quickly dashed hopes for another round of quantitative easing — the Fed's policy designed to push down long rates — and yields on the benchmark 10-year Treasury bond shot up in response.

During the week of the FOMC announcement, rates ran up 27 basis points to 2.31%, a four-month high.

“NOTABLE TURN’

The increase in the benchmark rate “marks a notable turn in the interest rate outlook,” Jeffrey Rosenberg, BlackRock Inc.'s chief investment strategist for fixed income, wrote in a March 16 update.

“The secular bear market in bonds has begun,” Larry Hatheway, chief economist in London for UBS AG, wrote in a research note.

An “improved and more durable global economic recovery” is causing the markets to challenge the Fed's commitment to keep rates low through 2014, he wrote.

Advisers are taking note of the changing sentiment.

The rate rise this month “doesn't mean rates will go up to 10% tonight, but it's been a definite change in the trend” since August and September, when rates fell after the credit downgrade of U.S. debt, said Greg Ghodsi, founder of 360 Wealth Management Group, which manages about $600 million.

At press time last week, bond prices were rebounding somewhat, bringing down rates.

But advisers are convinced that rates are headed up now, at least somewhat.

“I think we're at a historical bottom,” said Troy Daum, founder of Wealth Analytics, who manages $85 million. “Rates can only move up. Frankly, a lot of us would like to see that, to get some return on bonds.”

With rates so low, Mr. Daum continually has had to remind clients why they own bonds.

“We own them as a negatively correlated asset class to stocks,” he said. “When stocks get hammered, bonds are going up.”

And rates probably can't go up too high, given a less-than-vibrant U.S. economy dealing with slowdowns in China and Europe.

That is why the Fed won't risk damage from bond yields that rise too high, observers said.

“We might be range-bound” around 2.5% to 3% on the 10-year Treasury, said George Taylor, a portfolio manager with Moss Adams Wealth Advisors LLC, which manages more than $1 billion.

SOME BEARISH

If rates go higher, “some calamity will come up, and rates will [go] back down again,” he said.

Despite belief in such an auto-correcting mechanism, many advisers remain bearish on longer-dated bonds.

“If you're heavy in long bonds, which was the place to be, the proper move [now] would be to [slowly] get back to a more normal allocation” with shorter-term paper, said Mr. Ghodsi, who has moved a portion of his normal bond allocations into dividend-paying stocks.

“Going forward, it will be difficult, if not impossible, for bonds to generate a return,” he said. “So you have to maneuver a portfolio to get some yield” from both stocks and bonds.

“With new money, we counsel clients to stay a little shorter,” Mr. Taylor said. “If you can get 3% [on a bond], terrific; people still want bonds because [they know] they can get principal back.”

Mr. Daum likes some taxable municipals and recommends holding to maturity, given the outlook for higher rates.

“You can find some interesting bonds, eight to 10 years out” in the 5% yield range, he said.

“At this point of the business cycle, you need to switch from interest-rate-sensitive bonds to cyclical bonds,” namely high-yield paper, said Brian Carruthers, president of Brian Carruthers & Associates, which runs $65 million, mostly in bond funds.

“As the economy improves, the balance sheets of high-yield issuers improve, and there are fewer defaults. So it's a credit play,” Mr. Carruthers said.

Advisers are perhaps most worried about investors who have flooded into bond mutual funds over the past several years.

“Eventually, all the individuals who bought billions in funds, when they see a statement that went lower, that will be the trigger” to call the fund and sell, Mr. Ghodsi said.

“If fund managers get massive redemptions, the only thing they can do is sell,” driving down prices, Mr. Daum said.

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