Bonds

Bond pros: Volatility coming, but no 'tantrum'

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Look for a pick-up in issuance this summer

It has been nine years since the Federal Reserve last raised interest rates, a streak many investors expect to end in the second half of 2015.

Right now, the expectation is that the Fed will begin a series of measured rate increases in September. Another smaller group of fixed-income pros expects the rate hikes to start in December. Some outliers, including bond guru Jeffrey Gundlach of DoubleLine Capital, believe the Fed will not move at all this year.

What almost everyone agrees on is that the market will experience some volatility when rates rise, but not the level seen during the "taper tantrum" of 2013.

The anticipated rate hike by the Fed has been well telegraphed and is not expected to catch the markets off guard the way former Fed Chairman Ben Bernanke did in 2013. Two years ago, the then-Fed chief suggested the central bank might dial back on its bond purchase program, comments that surprised investors and sent bond yields soaring.

"Everything depends on the Fed," said Jim Caron, a managing director and fixed-income portfolio manager at Morgan Stanley. (Tweet this)

Given the Fed is depending on data to make its decision, Caron is keeping a close eye on gross domestic product and some key inflation numbers. He expects the Fed to move if economic growth ramps up to 3 percent in the second half of the year, if wage inflation picks up, and the Fed's favorite inflation metric, the Personal Consumption Expenditures price index, increases to 1.5 percent from the current reading of 1.2 percent.

When the Fed does raise interest rates, Pimco strategist Tony Crescenzi expects "short to intermediate term" bonds of out to five years will see the most weakness, something he said could hurt a lot of investors given so many are positioned there.

Jeff Rosenberg, chief fixed income strategist at BlackRock, said that how the economy performs is as important as what the Fed does.

He points out the second half of the year is seasonally stronger than the first half, and the U.S. could get an additional kicker as consumers finally feel comfortable enough to start spending the savings they have received from lower gas prices over the last six months.

If the economy starts moving faster than some had expected—at a time when the central bank has promised to take a "measured approach" to rate hikes—Rosenberg said the long end of the curve may start to steepen more sharply on inflation fears.

Rosenberg notes this is a contrary opinion, as many see the yield curve flattening at a higher level as short rates rise.

Expectations for inflation that may outpace the Fed's rate hikes could see the back end of the curve rise more than expected. He said that in this scenario, investors would be best served to overweight in the belly of the curve in the seven- to 10-year range, and underweight the short and long end of the curve.

The stronger economy and foreign investors seeking yield are expected to support one area of the bond market that is typically very vulnerable to a higher rate environment: high-yield corporate bonds.