Originally created 06/27/04

Bond funds still deserve a place in your portfolio

NEW YORK -- Bond investors must be feeling pretty grouchy by now.

The Federal Reserve is poised to start raising interest rates at the end of the month. Yields on the 10-year Treasury bond are climbing steadily, and bond prices, which move in the opposite direction, have been falling since March. So far this quarter, fixed income funds are down an average of 2.5 percent, according to industry tracker Lipper Inc.

Despite all this, most financial professionals agree average investors should own bonds, or bond funds - if only for the sake of maintaining a diverse portfolio. Bonds help balance equity risk, and they're still the best option for long-term investors who are looking for income down the line.

So what can you do to keep the bond portion of your portfolio afloat as rates rise? The steps you take depend on the size of your investment, your time horizon and goals and how much risk you're willing to take.

"This is a very good time to look at your overall allocation ... ask yourself if this is a risk you're comfortable with," said Ned Notzon, president of the Spectrum Income Fund at T. Rowe Price, a fund of funds that has shifted its focus to bonds at the shorter end of the yield curve.

"It's not something you have to do by Tuesday," Notzon added. "It's more important that you understand what you're doing, and not take a knee-jerk reaction and wind up with mediocre investments."

Longer bonds, which have maturities of up to 29 years, may seem like a good deal at first because they tend to pay higher yields. But when rates are rising, their value can fall. The value of bonds with shorter maturities - two to four years - won't drop as sharply, but the trade-off is that they pay less.

If you're invested in a diverse bond fund, chances are the portfolio manager has already sold off longer bonds in favor of those with shorter maturities. But if you hold more specialized bond instruments, you might need to make some adjustments yourself.

"If you're someone who really does truly actively trade, if you reallocate once a quarter, it's probably a good time to be entirely short, or not in bonds at all," said Andrew Clark, a senior research analyst with Lipper. "But if you're a passive, long-term investor, as long as you're diversified, you can ride this out."

Rates are currently at historic lows, so chances are they'll keep rising over the next two or three years. That means even if you only who reallocate once a year, it's still a good idea to shorten your bond maturities.

For active traders with larger portfolios, there are other ways to minimize losses during the next phase of the bond market. If you believe inflation will continue to rise, you might consider investing in Treasury Inflation-Protected Securities, or TIPS. Sold in five- and 20-year notes, TIPS are similar to U.S. Treasury bonds, but adjusted to eliminate the effects of inflation.

You could also hedge against interest-rate related losses with reverse bond funds, which are designed to perform in inverse correlation with the market. For example, if the bond market declines 2.5 percent, an inverse fund would go up 2.5 percent. This instrument, like TIPS, is for more sophisticated investors, and should only make up a small percentage of your total portfolio.

If you're currently relying on your bond portfolio for income, you might be better off reducing your bond exposure in favor of dividend-paying stocks, said Clark, of Lipper. A combination of equity income, tax-advantaged municipal bonds and real estate funds could be a good strategy for retired people looking to preserve their wealth while still earning some income.

For more passive investors who are starting from scratch, the easiest and cheapest way to get broad fixed income exposure is with a total bond market index fund. But the most important thing, financial planners say, is to understand the fundamental difference between bonds and stocks, and their risks.

When you purchase a stock, you're buying a tiny slice of a company - a piece of ownership and a claim on future income. If the company isn't run properly, or demand for its products and services falls, your investment might lose its value.

When you buy a bond, you're essentially loaning money to someone, whether it's the U.S. Treasury, a corporation or a foreign government, and that entity has agreed to pay you back with interest over a set period of time. Because no one wants to pay more than they have to, bond rates are competitive, and there's always the danger of default. When a bond pays a higher yield, it's because a credit rating agency has determined there's a greater likelihood of default, making it a riskier investment.

"Bonds are a very, very different type of investment than stocks," said Diane Maloney, president of Beacon Financial Planning Services in Plainfield, Ill. "They don't look alike, their performance won't be the same, but they definitely serve a purpose in your portfolio."

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