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By Christine Benz and Eric Jacobson | 09-27-2012 01:30 PM

Answering Your Questions on Bonds

Morningstar's Eric Jacobson responds to reader concerns about fixed income in the current low-rate environment, touching on duration, whether to sell holdings, the idea of moving into cash, and more.

Christine Benz: Hi. I am Christine Benz for We received lots of great questions in advance of our recent retirement readiness webinar. Many of them related to bonds. To help us answer them with thought we'd go straight to the source and check in with Eric Jacobson. He is a senior fund analyst at Morningstar, and he specializes in bonds and bond funds.

Eric, thank you so much for being here.

Eric Jacobson: I'm really glad to be with you Christine.

Benz: Eric, I would like to just start with a question of my own about the current interest-rate environment. So the Federal Reserve is saying that it's going to keep rates way, way down for the foreseeable future. What does that mean in terms of how investors should manage their interest-rate sensitivity [also known as duration]? Are they free venture into long-duration bonds because the Fed is saying it plans to keep rates nice and low? How should they interpret that statement from the Fed?

Jacobson: Well, the most tricky thing about it, Christine, is that they have different places on the yield curve or the maturity spectrum that they can operate. And when the Fed talk about keeping short rates low, which is really what they're saying, that's a place where you can pretty much rely on what they're saying, although I have talked to managers who don't believe, for example, that the Fed will keep them at rock bottom as long as they say they are. But let's just say, for example, for the sake of argument that you can take the Fed at their word. The bigger issue is how much longer they're going to continue to suppress long-term rates. And if you've heard a lot about QE2, QE3 in the news, that's what I'm talking about there. Those are cases in which they have purchased very long--well, not necessarily very long maturity bonds, in the case of mortgages they are not, they have long nominal maturities, but they don't tend to last as long as 30 years because of the fact that principal is getting paid down--but in any case, those purchases right now are suppressing longer-term rates.

And even though the Fed says they are going to continue with this latest QE3 round to buy longer-maturity bonds, it's a little bit hard to know how long that's going to take effect for or how long it's going to remain in effect and whether or not it will continue to have the same effect that it's having now, which is to suppress long-term yields. I think there are quite a few managers for example who worry that longer-term rates could see an upward trend at some point in the reasonably near future even if the Fed is keeping short-term rates so deeply suppressed.

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