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Bonds: Tempting yields, but more risk

Updated: May 3, 2013 12:15PM



The global bond market dwarfs the global stock market. The market for bonds is estimated at $67 trillion, with nearly half of those bonds originated in the United States. That compares to a global stock market valuation of just above $40 trillion, even after the market crash.

The $33 trillion of outstanding U.S. debt includes U.S. government bonds, corporate bonds, municipal (state and local) bonds, mortgage-related bonds, and short term money market securities. Most of these bonds trade daily, just not as visibly as the prices set in the stock market. So perhaps it's time to at least understand the global bond market and the opportunities it offers for portfolio diversification.

That's what's behind Fidelity's recent push to inform investors about bonds, and make it easier -- and less expensive -- to create your own portfolio of individual bonds or choose an appropriate bond fund to balance your portfolio. At www. Fidelity.com/fixedincomechoices there are online educational seminars, tools that help you choose from more than 10,000 bonds -- and more than 100 fixed income specialists who will help you over the phone.

Richard Carter, VP of fixed income securities at Fidelity Brokerage, says: "Our goal is to make sure that investors have a properly diversified portfolio. They need to know that there is an alternative beyond stocks and cash or money market funds. Bonds -- whether individual securities or an appropriate bond fund -- can fill that gap."

Fidelity has created an extensive set of Web tools to help wealthy individual investors construct a portfolio of individual bonds, and to create a "bond ladder" of similar bonds maturing in successive years. It's everything investors need to become their own bond portfolio manager. For those who want to devote less time there is a wide range of professionally managed bond funds available from Fidelity -- and every other fund management company.

Yet the ordinary investor rarely considers bonds as part of a portfolio, unless they are part of a diversified mutual fund that happens to own both stocks and bonds.

Bond basics

Before you start considering the role of bonds in your investments, you need to know some basics about the two risks in owning bonds.

The first is called "credit risk" -- the risk that the company might default on its interest payments. You can usually minimize this risk by purchasing highly rated bonds, with AAA being the top rating. And you can minimize the overall credit risk in your bond portfolio by purchasing a diversified group of bonds. That's easiest done through a mutual fund, where portfolio managers pick bonds for you.

The second risk is called "interest rate risk." It is simply the risk that if you lend money for 20 or 30 years at a fixed rate, any future increase in the general level of interest rates -- because of inflation -- will make your bonds less attractive.

If you pay $1,000 today for a 20-year top-rated corporate bond paying 5 percent, and in a few years they sell more bonds, but with a 7 percent interest rate, then your old, lower-yielding bond is less attractive -- and worth less in the marketplace. It will still pay $1,000 at maturity, but in the meantime you'll settle for a lower interest rate than others are receiving.

One more basic: the longer the maturity of the bond, the greater the price swing. After all, if you're stuck with a low yielding bond for many years, it's far more unattractive than holding a low-yielding bond with only a five year maturity.

Bond reality

Over the long run, history says that a portfolio of stocks will far outperform a portfolio of bonds. But there have been some periods when bonds outperformed stocks. We're nearing the tail end of one of those periods!

According to financial forecaster John Maulden: ''Starting at any time from 1980 up to 2008, an investor in 20-year Treasuries, rolling them over every year, beat the S&P 500 through January 2009."

That's because, in spite of the famous bull market in stocks that began in the early 1980s with the Dow trading around the 800 level, the bond market outperformed stocks as interest rates fell. In the early 1980s, amidst fears of massive inflation, yields on 20-year Treasury bonds were 15 percent. They've recently fallen to below 4 percent, creating tremendous profits along the way.

Remember, as interest rates fall, bond prices rise. And the reverse is true, as well. If interest rates were to rise sharply, amidst fears of future inflation, bond prices would fall.

So we're back to that old question of inflation vs. deflation. If you think the economy will remain slow, you can reach for slightly higher yields today on medium term government or highly rated corporate bonds. But if you fear inflation, don't buy bonds with maturities of longer than five years -- or you'll take a loss if you must sell them before maturity.

If you can't afford that risk, then stick to short-term "chicken-money" CDs or money market funds. A higher yield always offers a higher degree of risk. That's The Savage Truth.

Terry Savage is a registered investment adviser. Distributed by Creators Syndicate.



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