First, the 5 percent level on this benchmark yield represents the shattering of a long-standing ceiling. In the past three years, this level has been challenged several times: in summer of 2003, spring of 2004 and again in the spring of 2005. Each time, the surge has been turned back, mainly as fresh evidence turned up that the economy was slowing down in response.

When a market finally breaks through that kind of resistance, it usually keeps going for a while. There’s certainly a fundamental basis for a further rise this time around. Today’s employment report is pretty clear evidence new jobs are being created at a robust pace and that inflationary pressures continue to build.

The upshot is the Federal Reserve has little reason to deviate from its present course of pushing the fed funds rate higher, as it’s done for well over a year now. Like every other incoming Fed chairman, Ben Bernanke is anxious to prove his inflation-fighting credibility and can be counted on to keep tightening the screws.

No one’s anticipating that right now. As a result, the 10-year yield is likely to keep following the fed funds rate higher, every time the central bank takes it up another notch. Currently, the futures market for the fed funds rate is at 5.25 percent for June 2005. If current trends continue, therefore, we can expect a 10-year note yield at least that high by early summer.

Ultimately, what will end the Federal Reserve’s tightening cycle is emerging evidence that inflation pressures are cooling and, most likely, that the economy is slowing down. Unfortunately, with gold futures hitting $600 an ounce this week, oil prices still in the 60s, natural gas prices recovering and other commodities ticking higher, inflation is still very much front-and-center. Consequently, the end still looks a way off.

For as long as the 10-year yield has been in this trading range, my view has been the US economy is simply too leveraged to absorb the impact of rapidly rising interest rates, particularly with energy costs skyrocketing. That rule has held over the past few years, as every push higher in interest rates has been quickly met by a softening of economic indicators.

I continue to believe high debt levels will eventually prove to be a cap on rates. Borrowing--federal and consumer--is still climbing, and there’s an awful lot of adjustable rate debt out there as well.

Every time Bernanke and the Fed act to drive rates higher, it puts more pressure on consumers, businesses and even governments, squeezing out purchases and other expenditures.

The big question, however, is when that adjustment mechanism will kick in--i.e., how much higher interest rates will have to go before they head south again. In the past, the Federal Reserve has invariably overshot when it comes to raising rates, particularly when a new guy was anxious to prove himself as an inflation fighter.

Former Fed Chairman Alan Greenspan’s entry to the job in 1987 is the primary example. After inheriting his job from the ultimate inflation killer Paul Volcker, Greenspan jacked up rates dramatically that year to get a lid on prices and support the US dollar, pushing bond yields towards 10 percent and eventually setting off the dramatic market crash of October 19.

Whether Bernanke does anything that dramatic or not is something we’ll only discover over time. But it seems clear at this point that the benchmark 10-year Treasury note yield has further to rise, with 5.5 percent the next likely target on the upside.

If we’re lucky, the rising rate trend will end relatively painlessly as it has the past three years. Rates will peak and eventually come back down as inflation pressures cool. If this is a typical cycle, however, things could get quite ugly, no matter what you’re invested in.

Following The Benchmark

The second reason the breakout in the 10-year yield is important is it sets the tone for income investments of all stripes.

In 1987, the bond market and income investments began crashing about six months prior to the October collapse of the overall market. Bond yields began falling as the overall “growth” market collapsed and then moved markedly lower and income investments then followed suit.

That time around, selling was quite intense for the market’s most rate-sensitive sectors, though it was ultimately a superb buying opportunity for yield seeking investors. This time, the market’s most interest rate-sensitive sectors have largely brushed off the rise in rates, but we’re now seeing selling pick up, particularly for utilities which had several big down days this week.

As I’ve said before in this column, the only really big utility selloffs in the past century have been in the context of a wholesale collapse in fundamentals. The most recent example was in 2001-02, in the wake of the combination of the Enron collapse, market gaming scandals, dramatic overbuilding of natural gas-fired power plants and mushrooming of industry debt.

This time around, the fundamentals situation is the polar opposite.

Regulatory relations are still very positive at the federal level, as well as in virtually every state. The only real exceptions are in states where rate freezes are coming off, such as Maryland. But even here, the stakes are too high for all the parties for anything else but compromise.

The power market has been noticeably tightening as well. The clearest evidence is the way rates have become a political problem as freezes are coming off. There’s still a surplus of gas-fired capacity, but ownership is rapidly consolidating in some very strong hands particularly private capital. This week, for example, bankrupt Calpine Power (OTC: CPNLQ)--the biggest offender during the overbuilding of the late 1990s--announced a plan to emerge from bankruptcy after major power plant sales, a move that will simultaneously reduce debt and its need to produce from uneconomic capacity.

Finally, utility managements remain focused on cutting debt from their balance sheets, while eliminating riskier businesses. Even obvious opportunities to leverage networks like broadband over powerlines are being viewed with a jaundiced eye to hold down risks.

And management is being very careful to align its interests with shareholders.

For example, the new president of DUKE ENERGY (NYSE: DUK), former Cinergy boss Jim Rogers, has elected to forego a base salary and the company’s bonus programs in favor of a three-year compensation package set by future performance of the merged company’s stock, with a baseline of $29.14 per share. Rogers will not be allowed to sell shares in the ute’s stock until April 3, 2009, when his contract ends.

In short, the current situation with utility industry fundamentals couldn’t be more different from the high-flying 1990s. And as long as underlying business conditions are improving, there’s never been a major sector correction of more than 20 percent from the highs, even during the 1970s when interest rates were off the races on a spur of soaring inflation.

The utility averages peaked in mid-2005 at roughly 10 percent above current levels. That means--even in a worst case--we’re at least halfway through a correction that should end by early fall. Some individual companies will no doubt lose more, while others can gain.

But by and large, as long as you stick with high quality companies, the wise course is to hold on. And we can expect a strong buying opportunity as well in the coming months for stocks have long been out of reach after the sector’s biggest bull market move since World War II.

Real estate investment trusts are somewhat scarier for two reasons.

First, they’ve been running higher for six year and counting, including a strong performance in the first quarter. Second, should Bernanke’s rate moves really slow things down, their basic business could be hurt, even as rising rates boost interest costs and make their yields less attractive.

My advice remains to stick to the sectors that haven’t really run, particularly residential real estate. We were way out in front on this one in Personal Finance and are reaping the benefits with such bets as MID-AMERICA APARTMENT (NYSE: MAA) and HOME PROPERTIES (NYSE:HME). And with the cost of renting and the cost of buying homes still far from equalizing, there’s still a lot of room for improvement.

Moreover, sector valuations are far lower; Mid-America still trades at a yield nearly two percentage points higher than former PF recommendation BOSTON PROPERTIES (NYSE: BXP), which was recently added to the S&P 500. NEW PLAN EXCEL (NYSE: NXL), a former blue chip in the shopping center sector, still trades at only nine times funds from operations and yields nearly 5 percent.

As for bonds themselves, the best idea is to keep it short, specifically maturities of five years or less, or duration of five or less when it comes to bond funds. If you want something that will keep pace with whatever happens, the best bet is a “TIPS” fund like VANGUARD INFLATION PROTECTED SECURITIES (VIPSX, 8000-662-7447). TIPS are Treasury securities that automatically adjust their interest payments higher as rates rise. As a result, they keep pace with rising rates, just as a money fund does only at a higher interest rates.

If you own other closed and open-end bond funds, now is not the time to panic. Your best protection is that rates can only run so far before tipping the overall market into disaster, which in turn will push rates down. But in a worst case, you should also be prepared to see your principal lose value in the near term.

WHAT SHOULD HOLD

The bottom line for income investors is we’re likely to see more portfolio damage in the near term, but it will be reversed probably later this year. As long as your investments are maintaining--and hopefully increasing--their distributions, today’s red ink will be short-lived.

In times like these, the only investments it really makes sense to sell are stocks, bonds, preferred shares, etc. of companies that are weakening. They’re the only ones that really have significant downside in a rising rate environment, and everything else will rebound. And paring back weaker positions now also means you’ll have cash to buy when we do catch a top for rates, whether it happens in two weeks or six months.

There are some investments, however, that should do well in an environment where rates are rising and the overall market is still moving higher. One area is gold and precious metals.