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High selling prices/low yields spurred a record January for invest­ment grade bond issues. Dealogic data sets the tally at $136 billion, much of it long-term at record low rates.

The U.S. Federal Reserve's accommodative monetary policy has helped keep yields low, as have investor fears of a reprise of the 2008-09 stock market crash.

Inflows have forced managers of mu­tual funds and other major institutions to literally pay any price for available sup­ply. With corporations pushing out bond maturities and slashing interest costs rather than levering up, supply has been tight and prices have squeezed higher.

Rising bond prices have helped bond funds maintain returns, despite low interest rates. The question is what will happen when the music stops-i.e., when the economy picks up steam and the Fed lets interest rates rise.

Leveraged to Hilt

Individual bonds are exposed to two varieties of risk. First, rising interest rates erode principal-and the more dramatic the rise, the more crushing the retreat. The second is credit risk, the probability the issuing com­pany will be able to continue paying interest on the bonds and eventually redeem them at par value.

Since the 2008-09 crash, interest rate risk has been muted and it's likely to stay that way until the economy is back on its feet. Rather, credit risk has been the primary driver of bond prices.

Corporations have used record low borrowing rates to strengthen balance sheets. That's in large part a reaction to what happened in 2008, when companies that needed to issue bonds had to offer virtual loan shark rates.

To avoid a repeat, managements have minimized near-term refinanc­ing risk by extending debt maturities. That's cut interest costs and given companies flexibility with the timing of new offerings. In turn, bond fund managers have been forced to pay up for new supply, which makes compa­nies even more bulletproof.

Low corporate bond yields re­main the single biggest positive for the stock market in early 2013. And companies' stronger balance sheets make a 2008-style credit freeze all but impossible

Maintaining enticing returns at such low yields, however, has become pro­gressively more difficult for bond fund managers. Not only are they forced to pay top dollar for new bonds, but low rates also have made it attractive for companies to call away or redeem the higher rate bonds on their books.

Recent returns have been buoyed by capital gains on the called bonds. But increasingly, managers have had to either pay out less to shareholders, or maintain higher returns by increasing portfolio risk and/or leverage.

Bonds of lower credit quality gener­ally yield at least a few percentage points more than those of higher quality. Similarly, buying bonds that mature further in the future will also increase yield. Those measures, however, come at the price of greater exposure to a sudden slowdown in the economy and a spike in inflation, respectively.

Use of leverage or borrowing against the assets of the fund increases returns in the same way as buying a stock on margin. Benchmark interest rates are at low levels; so are borrow­ing costs for funds. The result has been much higher returns for many bond funds the past couple years than currently low interest rates would seem to allow.

Therein lies the danger in the bond market today. The annual return on an individual bond will always equal the yield-to-maturity when you bought it. Bond fund investors, however, can get burned if a manager has taken on portfolio risk and rosy bond market conditions worsen even a little.

Let's say austere federal budgets slow U.S. growth, as has happened in Europe. A bond fund that's shoul­dered considerable credit risk would lose principal as high yield bonds retreat. Equally, when the Fed allows rates to rise again, funds chasing yield far out on the maturity spectrum-say by loading up on 50-year plus debt- will get their heads handed to them.

Most at risk are bond funds employ­ing leverage. Both a slowdown and faster growth have the potential to raise borrowing rates for fund manag­ers. A significant rise in interest cost may force sales of assets to pay down debt. That in turn will dump new supply on the market, pushing down prices and potentially triggering even more selling.

Bear Market Protection

The biggest unknown is how much money a less accommodative Fed would drive out of bond funds. If that's significant enough, the drop in prices will bury leveraged funds, and incur big losses in others.

The easiest way to protect your portfolio is to own individual bonds instead of funds. As noted above, you never make less in a bond than the yield to maturity when you buy. By holding down maturities to five years or so-and sticking to solid dividend-paying stocks-your principal won't fluctuate much, even in the event of a full-scale bond market rout.

Buying individual bonds is a more complex enterprise than buying funds. The best bonds are not liquid, although any of a company's bonds will perform similarly. For best results, bond buyers should work with a good broker, many of which require mini­mum purchases of $10,000 or more.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: What To Watch For In The Bond Market