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

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

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.

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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.

Mr. Berry of Morningstar says a handful of broad-based funds stand out as possible core holdings. These include Metropolitan West Total Return, Dodge & Cox Income, and Harbor Bond. He also points to index funds designed to mirror the US bond market from Treasuries to corporate bonds: Vanguard Total Bond Market and Fidelity US Bond Index.

What if you're worried that interest rates will rise in the years ahead, due to inflation or falling foreign demand for US debt? One safety valve is bond funds with a shorter time horizon, such as Fidelity Short-Term Bond. A surer protection would be bonds whose returns are pegged to the inflation rate. These include the government's Treasury inflation-protected securities (TIPS) and Series I savings bonds.

Watch your costs. If bonds are paying about 5 percent interest, a mutual fund with an annual expense ratio of 0.3 percent cuts that return to 4.7 percent. Then, if the money is in a taxable account, that could fall again to about 3.5 percent (assuming a 25 percent tax rate). Factor in inflation, and not much is left.

So hunt for funds with no loads and low annual fees. And be wary, experts say, of bond ETFs, which charge a commission every time you buy or sell.

Municipal bonds can shield you from taxes, but the interest rate is often commensurately lower. Right now, municipals look attractively priced for people in the 28 percent tax bracket or higher, Berry says.

But some municipal interest is taxable under the alternative minimum tax. If you might be subject to the AMT, look into AMT-free funds offered by major fund providers.

Cash isn't trash – or king. A money-market fund may seem attractive now, paying interest that isn't that different from many bond funds. Cash won't lose its nominal dollar value as bonds can. But if inflation picks up, money-market yields often lag behind.

"To the extent that cash protects a portfolio against inflation, it does so tardily and after the fact," David Ranson, of H.C. Wainwright & Co. Economics in Hamilton, Mass., writes in a recent analysis.

Bonds or bond funds? Bond funds can be simpler to buy than individual bonds. And it can be hard for small investors to know whether they're getting a good deal on bonds sold by brokerage firms, especially corporate issues. But for TIPS or Treasury bonds, you can often lower your costs by buying on your own. Newly issued securities are available at www.treasurydirect.gov. In the secondary market, outfits like Trade King (www.tradeking.com) and Fidelity offer low-commission bond-trading desks.

Unlike corporate bonds, all Treasury debt is considered to be of virtually zero risk of default. But you'll need to plan your own "ladder" of bond durations, perhaps buying bonds of several different maturities to achieve the balance you desire.

"People have no business buying individual corporate bonds," says financial author William Bernstein in North Bend, Ore. But "buying Treasuries is a good idea, and buying TIPS in particular." The percentage of your investment portfolio that should be devoted to bonds can vary widely, even among people of similar age or means. It can also depend on your goals and risk tolerance, financial experts say. If your goal is to reduce the possibility of a sharp drop in your portfolio, bonds are useful for two reasons: They are less volatile than stocks, and they often zig when stocks zag.

"We expect stocks to outperform bonds in the future," says John Thompson, a portfolio manager at Ibbotson Associates, a Chicago firm that specializes in how to allocate money among various types of assets. But "bonds are an important diversifier," he adds.

A typical mix, for many people, might be 60 percent stocks, 40 percent fixed income (mostly bonds and some cash). Other advisers, departing from that classic mix, suggest that your bond percentage should equal your age, minus 10. If your goal is to build up money for a future need, bonds may play a dominant role if the target date is less than 10 years away.

For income during retirement, many advisers recommend both bonds and a fixed annuity that converts some of your savings into a guaranteed monthly income for life.

"The first question you have to ask is not how risk tolerant are you, but do you even know how risk tolerant you are?" says William Bernstein, author of "The Four Pillars of Investing." "If you lived through a bear market and you actually bought more stock ... then you are truly risk tolerant."

He expects future returns from the stock market to be in the range of 6 to 7.5 percent annually, not all that much better than the 5 percent or so he expects from bonds.

Mr. Bernstein adds that a 50-50 mix of stocks and bonds could post returns that compare pretty well with stocks alone, and with much less risk.

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