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Investment Guru: Higher Yields Are on the Way

That means bond prices are likely to fall. Here’s what to do.

James Paulsen is the chief investment strategist at Wells Capital Management in Minneapolis. Here are excerpts from our recent interview with him.

Have bond yields (which move in the opposite direction of prices) bottomed? We could revisit recent record-low yields. But whether the 10-year Treasury bond ends up falling to 1.3% or 1%, my guess is we’re close to the bottom.

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Are you the strategist who’s crying wolf? Many people believe yields, and rates overall, will stay low for a while. We’ve all cried wolf and then been muted. Bond yields have run me over more than once. But when everyone accepts the “lower for longer” argument—including the Federal Reserve Board at this point, I would argue—eventually there’s no one left to buy bonds and keep yields down.

Why are you convinced that the 35-year uptrend in bond prices has peaked? More things are pointing to higher yields today than at any point in the current economic recovery. With a sub-5% unemployment rate, even modest job growth will put upward pressure on wages. Prices for labor, services and now goods are starting to head higher, and not just in the U.S. Policy officials everywhere are pushing for economic growth at the same time. All of these things put upward pressure on interest rates. And there’s a disconnect between yields and other financial indicators. Bond yields are lower now than at any point during the Great Depression. Is the economy in worse shape than it was then? Absurd! There’s an argument that the Federal Reserve Board is sitting like an elephant on interest rates, distorting the message of the market. Even if you accept that, eventually the Fed will have to get up.

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How far and how fast do you expect yields to rise? I think you could see 10-year Treasury yields at 4% to 5% over the next three to five years. Economists often forecast nice, linear moves, but a good chunk of the rise in yields could be quite rapid.

What should investors do? Stay diversified, but close to your minimum exposure to bonds. I’d put money in lower-rated investment-grade munis or corporates, and a little in high-yield bonds. Keep maturities on the shorter side. Put some assets in Treasury inflation-protected securities, and consider offshore bonds. With stocks, tilt more toward international markets, developed and emerging, which are better relative values. I’d also tilt toward small and midsize companies, and favor industrials, financials and technology. Put a little into real assets, such as commodities, gold or real estate.

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