Interest rate warning, what the market may be saying now.Well, whispering maybe. The Dow popped over 12,000 for a day on Friday, October 28th, then promptly dropped 275 points on Halloween to ‘scare’ investors off. Can we find our way out of this and find some firm ground to justify stock investing again? We need to see the market start to establish a ‘higher low’ to be able to say we have found bottom. Whether it will or not remains to be seen. The recent band-aid over Europe gave some short term relief to stock investors around the world. But is this a real solution or just a continuation of ‘kick the can’? If we are headed for another slowdown here in the US, look for the Fed to implement another round of stimulus dubbed QE3. The stock market will lead upward if the Fed acts in this manner and the bond investor’s rough ride will be pushed further down the road.

Herein lies the warning to anyone holding a bond fund. It may be time to start to shift assets into certificates of deposit or money markets (unless you fear their portfolios) to protect your principal should interest rates change. Now I realize the Fed has promised no rate changes until 2013 at the earliest. But a funny thing may happen the closer we get there. Markets are forward looking and bond funds may begin to sell-off in anticipation. If you are holding bond funds for the long term and have no interest (pun intended) of selling in the event of rate hikes, then there is nothing to do, obviously. Also remember, the longer term, longer duration, bond funds will suffer the most as rates rise so they should be repositioned first. A simple rule of thumb is that a bond fund’s principal will decrease by the amount of the interest rate hike x the duration of the fund. So, a four year duration fund that has $100,000 invested will drop, on average, by $4000 should rates rise 1%. The situation gets more complex the lower the credit quality of the bonds in the fund you may own. Lower quality, or junk bonds, may drop more as investors sell to move to quality holdings as the economy strengthens and they don’t need lower rated bonds to get yield.

It is a very strange period for investors, especially those searching for yield. If you have the flexibility to do so, pay attention to your bond portfolios over the course of 2012 and start to think about adjusting durations to be in a position to protect as much principal as you can which will put you in a better spot to re-invest as yields rise. Should the Fed act on more stimuli, this eventual rate rise will be forestalled and equity markets will go on to another Fed induced rally that will not be sustainable. Just like stock allocations, bond holdings need some attention too once in awhile. We may be getting close to such a time.