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Good economy bad for bonds

USA Today

The economy is growing. Unemployment is falling. Bond investors have only one question: When will the hurting stop?

The bond market is the bizzaro universe of financial markets, where everything is backward: Good news about the economy sends traders into a funk, and bad news puts a spring in their step.

In 2004's first half, the economy improved, and nearly every category of bond mutual fund posted a loss. Unless something cheers it up - massive layoffs, perhaps, or a recession - the bond market will remain locked in a funk for the year's remainder.

The average U.S. government securities fund, a popular bond fund, fell 0.3 percent in 2004, including interest. Hardest-hit: funds that invest in bonds issued in emerging markets such as Brazil and China, down 3.2 percent.

That's nothing compared with the 2000-2002 bear market in stocks. What bond bear markets lack in depth, however, they often make up in length. Bond prices fell from the 1930s through 1981 - a bear market that earned bonds the nickname "certificates of confiscation."

The biggest bond bane: inflation. Bonds are long-term, interest-bearing IOUs. They pay a fixed amount of interest yearly. Consider $10,000 in a 10-year Treasury note; it pays 4.75 percent interest, $475, yearly until it matures in 2014.

Inflation erodes the value of that $475. After 10 years of 3 percent inflation, $475 has the buying power of $350 - a 26 percent loss. So when inflation looks likely, bond traders demand higher returns.

Traders can't change a bond's coupon rate. By bidding a bond's price up or down, they can change its yield, which is its interest payment divided by its price. If our bond's price fell to $9,000, its yield would rise to 5.3 percent. Push its price to $11,000, its yield would fall to 4.3 percent.

In the first half of the year, soaring oil prices spooked the bond market. The consumer price index rose at a steamy 5.5 percent annualized pace the three months that ended in May.

Even without the CPI's volatile food and energy components, the index rose 3.3 percent the same period. That's worrisome because rapid growth sparks long-term inflation. The Federal Reserve Board cures inflation by driving short-term interest rates up - in turn hurting bond prices.

Most bond-fund managers don't see the economy slowing anytime soon. "The perception is that rates will drift higher over the intermediate future," says Mark Durbiano, senior bond manager at Federated Investors.




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