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Bonds and borrowed time

Thursday, 25 Jul 2013 | 2:41 PM ET
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Bond market investors had a tough first half.

When interest rates rise, bond prices fall. This is confusing for a lot of folks, so imagine you own a 10-year Treasury note with an 8 percent coupon. If interest rates on new bonds being issued today were around 5 percent, your bond paying the higher rate of 8 percent would be worth more than par to a prospective buyer.

Conversely, if rates were to rise to 10 percent, you would not be able to sell your 8 percent bond for par because a prospective buyer could now get 10 percent elsewhere. This is what is known as interest rate risk.

(Watch: 'Bond Storm over: Pimco)

Another type of bond risk is credit risk.

If you own shares of a bond fund that holds bonds issued by a struggling company or government, you may see the value of your bond fund fall even though interest rates haven't moved very much.

This is because the ability of the issuer to pay interest and make good on principal is being questioned. The greater the uncertainty, the lower the bond price will fall.

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Many bond investors suffered declines as a result of both risks.

The Federal Reserve has been buying both Treasurys and agency mortgage-backed securities at a rate of $85 billion per month.

The Fed has undertaken this program of quantitative easing in order to keep interest rates at very low levels, thereby stimulating investment and consumption.

As a consequence of improved economic data, the Fed has now suggested that at some point in the future they may reduce the amount of their monthly purchases.

(Read more: US is healing ... if the Fed doesn't screw it up)

This suggestion spooked investors and rates moved higher. Higher rates mean that already struggling issuers, such as some municipalities, will have to pay even higher costs for new bonds they may issue.

This fortifies the economic headwinds they are facing already.

In stock land, earnings season is in mid-stream.

(Read more: Here's what you need to know on earnings (so far))

Reports continue to show lackluster revenue growth with modestly better gains on the bottom line. It strikes us as illogical that earnings will remain robust without increasing revenues.

Price-to-earnings multiples remain a bit above average and earnings margins for the S&P 500 are near all-time highs. If the gains in the equity markets are to be maintained, revenue growth must resume.

We have been through these ambiguous periods before and know that they can last much longer than most ever expect. When prices seem to creep ahead of fundamentals, we conclude one of three things: our evaluation is flawed (and prices and fundamentals are not out of line); fundamentals will improve to support prices or; prices will come down to a level supported by the fundamentals.

It is really important at periods like this to make sure that your holdings have substance: strong balance sheets, highly visible revenue and income streams, market share, and high-integrity management.

Michael K. Farr is president and majority owner of Farr, Miller & Washington, LLC. He is chairman of the investment committee and is responsible for overseeing the day to day activities of the firm. Prior to starting FM&W, he was a principal with Alex, Brown & Sons.

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