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The Year In Pictures: Interest Rates, and A Bond Tutorial

Interest rates are very low these days - after creeping up during the 1950s, 60s and 70s, they fell steadily during the 80s and 90s, and after dropping still further during the 00s, most types of rates are at record lows. That has made the last 30 years have been a great time for bonds, because their prices rise as yields in the market fall. But from today forward, rates can't drop much lower, so if you do own bonds -- and even if you don't -- it's a good time for a quick refresher.

Looking at the bond market today, three factors merit attention.

First is that the yield curve is exceedingly steep. Simply put, long-term rates are high relative to short-term rates. It's still true in a market where all rates are at record lows. The graph below, from, is the yield curve for U.S. Treasury bonds on January 5th.

That's good news for stock investors, says my MoneyWatch colleague Larry Swedloe in a recent post.

But that's generally not so for bonds, because if rates are low and the economy is strong, today's low rates have nowhere to go but up. Consider the patterns of rates in the next graph - after each recession, noted by the gray bars, rates tend to start rising in a year or two, as the demand for credit increases.

One exception to that rule is the period following the 2001-2002 recession (in the circle), when the Fed kept rates artificially low, inflating bubbles in real estate, both commercial and residential. Yes, the red line rose in 2005 through 2008, but compare it to almost any other point from 1960 on.

The point is that rates are really, really low, no matter how you measure them.

The second observation is that bonds with a shorter maturity are less influenced by changes in rates. That has to do with the math of bonds, and how long into the future a bond is earning a fixed rate. If a bond is locked up for 10 years paying, say, three percent, and rates go up to four percent, its value today is lower than one that is locked up for just five years, because you get your principal back sooner and you can it at the higher rates.

My third observation is that the bond market is divided up into many different compartments, determined by who is doing the borrowing and investing. It's more like a flea market, with buyers and sellers of many different types of merchandise, than say a bakery, where one seller offers a few variants to customers looking for the same thing.

Consider the table below, showing a few different market segments and the returns they have earned lately. To make the exercise more realistic, I took the returns of several funds of Vanguard Group, because the returns of bond indexes can differ from real-world performance for several reasons. I happen to be a Vanguard customer, but I am not a shill for them; instead I choose their funds because their portfolios are large, established and have low fees.

The 10-year Treasury yield rose 1.3 percent in 2009, after falling that much in 2008. Look at how the two Treasury funds performed in those periods: the long-term fund fell a lot in 2009 and rose a lot in 2008. Moves in the short-term fund were in the same general directions, but dampened.

The investment grade funds were altogether different, because the credit crisis affected another important variable in their returns - the premium investors demanded for credit risk. High yield corporate bonds were different still, because their returns are more closely linked to the stock market.

TIPS bonds are a different animal, designed to provide a return tied to inflation, and are outside of this discussion. But even though inflation was low during the entire period except for a portion of 2007, TIPS still gyrated quite a bit.

Steadiest of all bond funds over this short sample period was the GNMA. These funds invest in mortgage-backed securities, albeit ones carrying an implicit government guarantee, and they tend to be short in maturity. They are boring, even compared to other bond funds, but have been reliable.

But if rates rise sharply, as some observers expect over the coming three to five years, even GNMAs could be jeopardized. Take as an example 1994, when the Fed made a surprise tightening and the 10-year Treasury rate rose two percentage points: long-term Treasuries and investment grade bonds fell seven and five percent, respectively. High yield bonds rose 14 percent for the year, but everything else fell a little, including a one percent drop for GMNAs.

Considering how little room there is for interest rates to fall, 2010 may not be the year to start buying bonds. Nevertheless, most investors should hold a portion of their portfolios in bonds, and everyone else should be conversant in the strengths and weaknesses of bonds, because we will all need the relative stability of bonds sooner or later.

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Investment disclosure: The writer owns an exchange-traded fund that benefits from rising interest rates.