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Fixed-Income Bears See Trouble in Fed's Reflation Policy 

Gregor Schuster | Getty Images

bears have a powerful ally in their corner: the U.S. Federal Reserve .

While the Fed’s zero-interest rate policy has kept Treasury bond prices buoyant, its long-term priorities are working against fixed income. Its Operation Twist is designed to keep a lid on long-term rates, encouraging investors to embrace riskier assets than bonds. Quantitative easing , meanwhile, should weaken the U.S. dollar and ultimately ignite inflation .

“Once started, inflation is very difficult to stop quickly,’’ says Scott Colyer, chief investment officer of Advisors Asset Management in Monument, Colo. “Rising inflation would tend to produce higher interest rates and lower bond prices.”

When rates rise, long-term bonds typically suffer the greatest price declines because the longer timeline means greater uncertainty and vulnerability. This group includes 10-year and longer U.S. Treasurys, as well as investment-grade corporate bonds.

The improving performance of Treasury Inflation-Protected Securities, TIPS, is a further warning signfor bondholders.

“Within the bond market, inflation expectations are coming back,’’ says Michael Gayed, chief investment strategist at New York’s Pension Partners, pointing to the fact that junk bonds and TIPS are now beating Treasurys. “Even on risk-off days, TIPS are still outperforming.”

The threat of inflation and higher interest rates isn’t the only headwind facing the Treasury market, Colyer points out.

The Fed has been the largest buyer of U.S. government debt, propping up prices and pushing down yields . When the buying spree ends, prices and yields could see a sharp correction, even on the shorter end.

“Broadly speaking, Treasurys are overvalued throughout the [yield] curve,’’ adds Chris Molumphy, chief investment officer of Franklin Templeton Fixed Income Group.

Resolution of Europe’s debt crisis and reduced volatility could also cause U.S. Treasurys to lose their safe haven status.

Options for Investors

Investors can benefit from the expected Treasury selloff by betting against them. This can be done by shorting long-bond ETFs like iShares Barclays 20+ Year Treasury Bond , or by buying inverse or short ETFs like ProShares Short 20+ Year Treasury that aim to deliver the opposite performance of the bonds they’re shorting.

Nicholas Oleson, a financial adviser with Philadelphia Group in King of Prussia, Pa., says inverse ETFs are more liquid and cost efficient than trying to short long-only ETFs.

While rising rates hurt fixed-rate bonds, those with floating interest rates or rates that reset quickly can gain from an increase in borrowing costs.

Bond bears say the leveraged loan market is one of the few sectors they like. Floating rate loans adjust their interest rates every 45 to 60 days based on LIBOR , a short-term benchmark rate, and thus pay higher coupons as rates rise.

Short-term bond funds, which invest in bonds, usually notes, maturing in two years or less, can also benefit from replacing maturing bonds with new ones paying higher rates.

Besides the Fed, the European debt crisis has exerted the strongest influence on bond markets. A Greek default in the first half of 2012seemsimminent. The question is whether it will be controlled or chaotic. Portugal is also teetering, while Italy, Spain and France have been hurt by credit downgrades.

The European Central Bankhas joined the Fed in implementing an ambitious quantitative easing program to provide much needed liquidity and avert a double-dip recession.

While the monetary action is encouraging, European governments and banks alike face an uphill climb in cutting debt. With so much uncertainty, Franklin Templeton’s Molumphy recommends keeping your portfolio underweight in European bonds.

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