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Treasury bonds sell-off hurting bond funds

The seal on the U.S. Treasury building in

The seal on the U.S. Treasury building in Washington, D.C. (August 2011) Credit: Getty Images

Bad things are happening in U.S. bond funds this month -- and quickly.

A steep sell-off in U.S. Treasury bonds is hurting bond funds. Particularly hard hit are funds holding long-term debt, which is sensitive to surging interest rates.

Some of the worst performers are down more than 10 percent in May.

Bond funds that loaded up on dividend-rich stocks and junk-rated debt months ago are doing the best. They have shielded their investors from a surge in the 10-year Treasury yield, which peaked at 2.235 percent Wednesday, its highest since April 2012.

Bond prices move in the opposite direction to their yields, so rising yields mean bond prices are falling.

Overall, the Treasury market's sudden turn, based on fears that the Federal Reserve may end its vast easing program soon, has hurt most fixed-income investors.

On average, bond funds with at least $500 million lost 0.91 percent so far in May, according to Lipper, a unit of Thomson Reuters. Over 80 percent of all such funds have lost money in May.

The small group of winners diversified by moving away from Treasury bonds and longer-term securities.

The $15.4-billion Loomis Sayles Strategic Income Fund, for example, got a boost in May from a big bet on dividend-paying common stocks like Corning Inc., its largest holding. The stock also is up 24 percent this year, with an 8 percent surge in May.

The fund gained 0.71 percent in May, among the best of all bond funds, according to Lipper. Stocks like Corning can be bond substitutes because they pay attractive dividends with yields better than investment- grade debt, Loomis Sayles portfolio manager Matt Eagan said.

"Our expectation is that rates are going to rise," Eagan said. "We think the first cycle in a multi-cycle environment is under way."

Since 2006, investors have pumped nearly $900 billion into U.S. bond funds, while yanking $536 billion from stock funds, according to BofA Merrill Lynch Global Research. But investors are quickly waking up to the fact that bond funds can lose money, too.

There is little agreement among bond fund managers about how quickly interest rates may rise over the next 18 months.

Faster economic growth would be the fundamental cause of higher rates, and that's not likely, said Ford O'Neil, manager of the $14-billion Fidelity Total Bond Fund. "Over the next 12 to 18 months, we don't see the economy breaking out," he said.

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