If You Own Fixed Income Funds, Watch for this Major Shift

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The worst of the “fiscal cliff” impact may have been averted, at least for the moment. But now investors face a new concern: The debt ceiling drama and its affect on fixed income assets.

The U.S. reached the current statutory debt limit of $16.4 trillion on December 31, 2012. And the Treasury Department has been employing creative financing measures ever since to finance about $200 billion in deficits in 2013.

This means Congress must act, again, as early as mid-February to prevent a U.S. debt default. Recall that a similar debt drama played out in the summer of 2011 leading to a downgrade of the U.S. credit rating. Now here we go again!

Washington essentially kicked the can down the road again with some tax increases, but no meaningful spending cuts. Instead, the $110 billion in automatic spending cuts have been delayed for a couple more months. In other words, this deal does little to address America’s chronic deficits.

As a result, we can surely expect more volatility in financial markets early this year as the debt ceiling drama plays out.

But …

The Bond Market Will Likely
Get Hurt More Than the Stock Market

With fiscal cliff uncertainty hanging over the markets in recent weeks, you might have expected U.S. Treasury bond prices to surge higher. That’s the typical flight-to-safety trade we’ve seen in the past, including the last debt ceiling drama in 2011. But the opposite happened this time around.

In fact, Treasury bonds have been falling steadily in price with interest rates rising in recent weeks. The iShares Barclays 20 Year Treasury Bond ETF (TLT), which tracks long-term government bonds, was one of the worst performing during the month of December, falling 2.9 percent. And it was down for full-year 2012 while the S&P 500 Index gained 13.5 percent.

The question for investors: Is this just a short-term reversal for Treasury bonds, or a lasting shift in trend.

chart1 If You Own Fixed Income Funds, Watch for this Major Shift

Treasury bonds have been enjoying an unprecedented bull market since interest rates peaked in 1981. In the three decades since then, 10-year U.S. Treasury bond yields have declined from a high of 14 percent, to just 1.5 percent last year.

The corresponding gains for bond holders in recent years have been impressive. In fact, TLT has produced total returns of 11.2 percent over the past five years, and 7.8 percent over the past decade.

These equity-like returns are well above the norm for fixed income funds. And just like the unsustainably high returns for stock funds during the 1990s, they certainly can’t be counted on going forward.

The Risks Ahead …

After such a dramatic decline for interest rates, it’s clear the risks are on the upside with higher rates likely in the years ahead. In fact, it’s only a question of when — not if — yields will begin a sustained uptrend with bond prices falling.

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