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As Dow soars, don't give up on bonds just yet

Long term, bonds still make sense in any portfolio. Here's what to consider now.

By Staff writer of The Christian Science Monitor / May 21, 2007

While the stock market has been soaring to record highs, bond investors have been taking a bath.

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It's not unusual for the two markets to move in opposite directions, but the divergence lately has been striking. The Dow Jones Industrial Average rose 1.7 percent during the trading week that ended May 18, closing above 13500 for the first time.

But the 10-year US Treasury note was plunging unusually fast for a bond, losing more than 1 percent of its value.

What's going on here, and what does it mean for people who look to bonds as a safety valve or for retirement income?

Recent news reports have reassured investors that the economy is healthy and likely to dodge a recession in the near term. Though bullish for stocks, that news caused the bond bulls to run for the hills. Bond prices move in the opposite direction from interest rates, and interest rates tend to fall when the economy weakens.

For the long-term investor, this doesn't mean it's time to bail out of bonds. In fact, many advisers say bonds are as important as ever to a long-term financial plan.

Yet the recent setbacks are a reminder that bond investing requires attention and discipline just as stock investing does. And for now, the market mood suggests caution in regard to bonds.

"I think they're going to be range-bound for some time," with no big breakout in either direction, says Jeff Tjornehoj, a senior research analyst who tracks bond mutual funds at Lipper in Denver. Bonds "are having a hard time stating a good case," he says.

Financial experts say now is a good time to recall, and put into practice, several rules of thumb:

•Choose the right mix of stocks and fixed-income investments. Despite the justified talk about relying on stocks for the long run, bonds should also play a role in most portfolios

•Consider the mix within your fixed-income holdings. Short-duration or inflation-protected bonds offer the most safety, while longer maturities and riskier bonds can boost your current yield.

•Hold expenses to a minimum. With fixed-income investments in particular, every penny of fees or taxes weighs against your income. New exchange-traded funds (ETFs) for bonds can load you with commission charges. "AMT free" funds can lighten your liability under the alternative minimum tax.

•Be aware that cash is even safer than bonds. Assets stashed in a money-market fund won't fall in value, the way bonds recently have. But that doesn't mean cash holdings are without risk. They can sometimes fall behind inflation and rarely outpace inflation by much.

•Weigh the benefits of mutual funds and individual bonds. You may choose to buy government bonds on your own, while turning to mutual funds to cover the corporate-debt spectrum.

These are steps that may benefit you, even if you're having difficulty knowing where interest rates are headed next.

In recent months, economists and market strategists have struggled to read the tea leaves on that very point.

Some worry about recession. They point to a weak housing market and the burden of rising food and gasoline prices on consumers. These have been the bond bulls.

Others say the economy's solid fundamentals – everything from rising exports to low unemployment – make a recession unlikely. Also at the opposite extreme from the bond bulls are those who worry that inflation won't soon be tamed. Inflation is the worst enemy for traditional bonds, because it eats away at the value of a bond's promised stream of income.

"That seems to be the big question: Where does inflation go, where does the economy go, where does the Fed go?" says Scott Berry, a senior bond-fund analyst at Morningstar, a Chicago rating firm. "There's not a lot of agreement."

As of last week, with concern about recession fading, investors mostly gave up hope that the Federal Reserve would cut interest rates to stimulate the economy. Rate cuts tend to buoy bond prices. Yet the Fed also may not need to raise rates, either. The latest gauge of consumer prices suggests that inflation may be cooling a bit.

This market consensus could change, pushing bonds in either direction. In a survey this month, the median forecast among economists is that the 10-year Treasury note will yield 4.9 percent by December, up a bit from 4.8 percent today. The highest five forecasts in the survey averaged 5.24 percent, while the lowest five averaged 4.28.

Against this backdrop, what can fixed-income investors do to position themselves? Here's what some bond analysts and financial advisers recommend:

Mix and match. Many experts say diversification is just as important among bonds as it is among stocks.