Midyear Investment Review and Outlook : Bond Owners Face Decisions As Losses Mount

Here’s a simple test for bond market investors who are still shellshocked from their experiences of the last six months:

* How much money did you lose, on paper?

* Would it bother you to lose that much again during the next six months?

If the answer to the second question is “absolutely not!” then you may have reached your psychological limit as a bondholder.

The problem in the bond market during the first half of this year wasn’t so much what occurred--i.e., rising market interest rates--but that investors who thought they were prepared for it really weren’t, some Wall Streeters say.

Before this year, most bond owners had made great money in the market every year since 1988. That was because interest rates had been in a general downtrend through that entire period, so older, higher-yielding bonds kept appreciating in value. Investors got a capital gain “bonus” on top of their annual interest earnings.

Bond pros often talked about what would happen when market interest rates would rise again, but people began to forget that rates moved in both directions.

Now rates have soared across the board, pushed up by the Federal Reserve Board and the economy’s strength. The result is that the share values of many long-term bond mutual funds lost a stunning 8% to 12% in the first half, as older bonds depreciated.

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Because the funds’ bonds kept earning interest in that period, shareholders’ total return --principal loss offset by interest income--is in the negative 4% to 8% range for many long-term funds.

Even short-term bond funds, which their owners viewed as relatively secure, came out of the first half with 2% or so negative total returns--testimony to the broad surge in interest rates.

What happens next, of course, depends on a host of factors, mainly economic. Slower economic growth could mean that interest rates will fall back for a while, recouping some of bonds’ principal losses.

Even so, Prudential Securities economist Richard Rippe concedes that all bond owners have to face the reality that the world economy is inexorably getting better and that that means the easy-money days of bonds are over.

“If you look out over the next 18 months to two years, I think interest rates are going to be higher,” Rippe says.

“The secular bull market in bonds is over,” agrees Richard Hoey, economist at Dreyfus Corp. But he notes that interest rate changes from year to year could be so modest that bondholders will experience neither appreciation nor depreciation of principal; they may just earn their interest, which is what most are in for anyway.

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If you’re in bonds because you need income, there are easy ways to make yourself feel less vulnerable to principal losses, experts say. One simple idea is to split your money evenly among short-, intermediate- and long-term bond funds, rather than keeping it all in long-term funds (which most people have done because the yields are highest there; they forget the risk to principal is highest as well).

Another idea: Get out of funds and build a “laddered” portfolio of individual U.S. Treasury securities or other bonds, with some maturing every two years for, say 10 years.

That way, you’ll have money rolling over periodically, and you won’t face the constant worry of the fund owner: that, because a fund is open-ended (and thus never matures) you can never be sure of getting your original principal back in a long bond bear market.

Bonds: How Much Worse Can It Get?

As long-term interest rates have jumped this year, investors who have stayed in bonds have seen the bonds’ value erode. Here’s how the principal value of four types of bonds would change over the next year under two different interest rate scenarios.

Principal change over next year Current if market interest rates: Treasury bond term yield RISE 1 point FALL 1 point 2-year 6.17% -0.8% +1.2% 5-year 6.95 -3.2 +3.7 10-year 7.32 -5.9 +6.8 30-year 7.61 -10.7 +13.4