So you’re waving the white hankie and pulling record amounts of money out of equity mutual funds. Market analyst Steven Leuthold, of the Leuthold Group in Minneapolis, estimates that fund managers sold about $36 billion worth of stocks in July just to meet redemptions. And where is the flight money going? Record numbers of investors are discovering bonds.
I’ve always been a fan of holding some investment money in bonds. As you’ve recently seen, they often gain value when stocks decline. “You own them because you don’t know what the future holds,” says Jay Mueller, head of fixed income at Strong Funds in Milwaukee. Since March 2000, in one surprise, Vanguard’s intermediate Treasury fund has gained 32 percent.
If you’re like most investors, however, you don’t know much about the theory and practice of bonds. We’ve all been so stock-obsessed, we never got the knack.
To invest in the fixed-income market, there’s one key concept you need to grasp. A change in the level of interest rates changes the market price of the bonds you own. If interest rates rise, the value of your bonds will fall. If interest rates fall, your bonds will rise. The reason quality bonds have done so well in the past couple of years is that interest rates declined. The longer the term of your bond, the higher its market price may rise–or fall.
This leads me to the first no-no for bonds. Avoid long terms–no 20-year municipals, no long-term bond funds. These bonds pay higher interest rates. But the extra payment normally isn’t high enough to compensate you for the higher risk, says Larry Swedroe of Buckingham Asset Management in St. Louis and author of “Rational Investing in Irrational Times.” During inflation, you’ll lose purchasing power, too.
If you buy a long-term fund today and interest rates rise (as they’re likely to when business improves), your fund will fall more in price than bond funds with shorter terms. If you own a 20-year tax-free municipal bond and have to sell early, the broker will force you to take a discount. Best bet: choose intermediate bonds (maturing in five to six years) or short-term bonds.
Another mistake is to switch your long-term savings entirely into bonds. Because of their price fluctuations, bonds are not as certain as they sound. Charles Jones and Jack Wilson, finance professors at North Carolina State University in Raleigh, looked at various combinations of bonds and well-diversified stocks over two 25-year periods since World War II. A port-folio containing about 60 to 65 percent bonds, with the rest in stocks, was no riskier than owning all bonds and yielded a higher return, besides.
One more tip: over time, bond funds with low expenses should beat higher-cost funds. The Vanguard group offers the lowest-cost retail bond funds (under 0.3 percent a year). Low-cost DFA sells through investment advisers. If you work with a stockbroker, look at Pimco Total Return, which buys bonds with intermediate terms. Pimco isn’t cheap; you pay sales expenses. Still, it’s managed competitively.
A smart way of using fixed-income investments is to choose safety first. Consider buying a short-term fund, whose bonds mature in two or three years, Swedroe says. They yield more than banks (3.3 percent with governments; 4.5 percent with quality corporates) and are stable enough that you can afford to keep more of your money in stocks. By rolling them over each time they mature, you earn the latest interest rate, which gives you inflation protection, too.
Investors are flocking to Treasury securities today because they’re default-proof. That has knocked down their yield to less than half of what short-term corporates pay (just 2 percent for a two-year Treasury; 3.9 percent for 10-year terms, a 40-year low). Although Treasury funds gained the most during the recession, they could lose the most when rates rise again. For a little more risk, the Bank Credit Analyst in Montreal prefers funds that buy corporates.
For income, investors often turn to high-yield funds. These own junk bonds from riskier companies rated BB or less for safety. Unlike other bond funds, junk funds lost money this year (down 5.6 percent) due to record defaults, especially among telecoms. But current yields run at 10 to 11 percent, which pays you for the risk, says Prof. Edward Altman of New York University’s Stern School of Business. Scott Berry, bond analyst for Morningstar, says that during economic recoveries, junk funds have earned double-digit returns. Still, gamble with only a little money.
At the end of August, high-yield bond funds were reporting the highest inflows on record. Are people crazy? Maybe not. When scared investors wave white hankies, it often means the worst has passed.
