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By Christine Benz | 04-20-2010 04:28 PM

What Rising Rates Mean for Your Bonds

Morningstar's Eric Jacobson on the mechanics of rising rates, the most sensitive areas of the bond market, and some practical tips for worried investors.

Christine Benz: Hi, I'm Christine Benz for Morningstar. What will rising rates mean for bonds and bond funds? That's a burning question for investors today. Here to answer that question for us is Eric Jacobson. He is director of fixed-income research for Morningstar. Eric, thanks for being here.

Eric Jacobson: Glad to be with you, Christine.

Benz: Let's start with a basic, functional question. It's been a while since we've had a sustained period of rising interest rates. Can you discuss, Eric, the mechanics of what happens in a rising rate environment and why that tends to be bad for bonds and bond funds?

Jacobson: Well, let's just start with the fact that when people talk about rising rates, it's important to distinguish between what is affected by the government, which is principally what people refer to as Fed funds--which is the rate that's controlled by the Federal Open Market Committee.

That's something that changes depending on meetings that they have every few months, and it's what's referred to often as a "policy rate." Usually, that's a very short-term rate. Right now, it's targeted between 0 and 25 basis points, or a quarter point. It's very, very low.

When that number changes, it will very likely affect a lot of different rates that are linked to it. Whether it's corporate borrowing, or any number of loans of any kind that might be linked either to Fed funds--or more likely, some other rate that benchmarks off of it or very close to it, like LIBOR--that could really affect borrowing costs for a lot of entities.

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