Bonds Suddenly All the Rage, but Are They Really for You?

A lot of people who never thought they’d look at a bond, much less buy one, suddenly have had a change of heart.

With long-term bond yields falling to 20-year lows this week--while stocks are struggling in the face of economic worries--bonds have become the asset of the moment on Wall Street.

Federal Reserve Board Chairman Alan Greenspan, by raising the specter of deflation in a speech last weekend, just cranked up the wattage on the spotlight that has been shining on the bond market for the last three months, as falling interest rates have boosted bond values and convinced more investors to grab current yields before they disappear, maybe for a long time to come.

It would be great if the best financial advice today could simply be: Sell stocks, buy bonds. Unfortunately, for many investors the issue is far more complicated.

Should you buy bonds? Here’s a basic primer to help you decide:

* First question: Why do you think you need bonds? Are you anxious to lock in current yields because you need income to live off of, and fear that interest rates could drop a lot more in coming years should the economy slow and/or low inflation turns into actual deflation? Or are you just eager to have a “buffer” against a potentially sharp drop in the stock market?

Or perhaps your interest is more speculative: Are you looking to make a short-term killing, should bond yields continue to decline, thus boosting the principal value of existing bonds that pay higher fixed yields?

The type of bond investment you should buy, if any, may vary greatly depending on how you answer the “why” question.

An investor who needs income, for example, may want to invest in a “laddered” bond portfolio. That involves buying individual bonds (such as U.S. Treasury issues, or tax-free municipal issues) maturing in stepped fashion--say, in two years, in five years and in seven years. The idea: You lock in yields, but ensure that some of your money is always coming back to you in the not-too-distant future for reinvestment.

A Treasury, corporate or muni bond mutual fund also may serve such an investor well, although note that funds’ yields aren’t fixed because their bond portfolios are constantly changing.

By contrast, an investor who is merely looking to make a fast buck if bonds continue to rally (i.e., yields continue to fall) may want to buy long-term, zero-coupon Treasury bonds. Because they don’t pay current income (although you’re taxed on it annually anyway) but rather generate all of their return at maturity, their market prices reflect that--making them the most aggressive way to bet on interest rate trends.

One easy zero-coupon bond option: American Century Benham Group’s “target-maturity” funds. For information: (800) 345-2021.

* Second question: What are your investment return expectations? Stocks generate a higher rate of return over the long run than bonds. That is a basic fact of life in investing.

Why is that so? Because stocks, which can lose 50% or more of their value in bad times, are inherently riskier than bonds, which tend to be far more stable (boring, some would say) thanks to their interest component.

Thus, you should be rewarded for taking the extra risk in stocks over time.

Since 1925 U.S. stocks’ average annual total return (price gains plus dividends) has been about 11%. In that same time frame the average annual total return from long-term Treasury bonds has been about 5.3%, or roughly half of stocks’ returns.

Over the last five years, however, stocks’ performance has been far above the historical norm: The average stock mutual fund has returned three times as much as the average bond fund (121% versus 40%).

Investors might infer from that huge gap that bonds have some catching up to do--which could happen if stocks’ returns become disappointing while bonds’ returns simply match their historical norm.

But in the long run, if you’re still interested more in capital appreciation than capital preservation, you’ll want to have the lion’s share of your financial assets in stocks.

* If what you want is a temporary hedge against falling stock prices, think about money-market accounts or short-term CDs rather than bonds. The average money market mutual fund now yields about 5.3%. The yield on a five-year Treasury note is 5.41%. So you aren’t being paid much more today to make a five-year bet with your money (although, of course, you can always sell a bond) versus keeping it in short-term account.

If you shift money to bonds or bond mutual funds as a hedge against stocks, you may have transaction costs to get in, and then to get out. Plus, if market interest rates surprise everybody and rise instead of falling in the months ahead, your bond bet may lose you money (remember--a fixed-rate bond’s principal value falls as market rates go up, because new bonds obviously are more appealing).

If all you really want is a parking place for cash until stock prices get cheaper, or other investment opportunities arise, money-market funds or other short-term accounts may be your best option.

* If you’re making a portfolio shift to bonds for the long term, try to do it in a tax-sheltered account. Let’s say your stock assets have appreciated dramatically in recent years (they should have). Now you’re interested in permanently shifting some of that money to bonds, as a long-term capital-preservation move.

If possible, make that shift in your tax-sheltered retirement accounts (such as a 401[k] plan or an individual retirement account).

Why? Interest income is taxed at ordinary tax rates, so it’s best to shelter bonds from Uncle Sam if you can. That also allows the interest to compound over time.

Long-term capital gains on stocks, on the other hand, are taxed at much lower tax rates. So owning capital-gains-generating investments outside of tax-sheltered accounts makes sense for many investors, especially in the case of individual stocks that allow you full control over when a capital gain is realized (as opposed to stock mutual funds, where you might not have much control of gains payments).

*

Tom Petruno can be reached at tom.petruno@latimes.com

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Catch-Up Time?

Stocks have returned far more than bonds over the last five years, but could bonds be ready to narrow that performance gap? Total returns on the average general stock fund versus average taxable bond fund, five years ended Dec. 31:

Stock fund avg.: +121%

Bond fund avg.: +40%

Source: Lipper Analytical Service