Bonds Prove Their ‘Cushion’ Value as Stocks Tumble

For too many investors over the last few years, asset allocation meant owning some Yahoo, some Cisco Systems, a little Microsoft and the dot-com of the month.

Bonds? Those were for old fogies.

But bond mutual funds trounced stock funds in the first quarter, and over the last year some bond fund categories have produced double-digit total returns, meaning interest earned plus gain in principal value.

At the very least, owning some bonds was a way for investors to offset serious losses in their stock portfolios.

In part, bonds have won because stocks have lost: As share prices have tumbled, many investors have sought refuge in Treasury securities. Amid strong demand, yields on new bonds have fallen--boosting the value of older, higher-paying bonds.

Treasury yields and yields on other high-quality bonds, such as corporate issues and tax-free municipal issues, also have dropped because the Federal Reserve has cut interest rates as the economy has slowed.

Nearly all bond fund categories showed gains in the first quarter:

* Long-term investment-grade funds, which own high-quality corporate issues, had an average total return of 3% in the quarter, according to Morningstar Inc. Over the last year, the funds are up 9.9%, on average.

* Municipal bond funds overall gained about 2% in the quarter and are up between 7% and 10% over the last year in total return.

* Long-term government bond funds rose 1.8% in the quarter and are up 12.4% over the last year.

* Corporate junk bond funds rebounded in the first quarter. Those funds gained 3.6%, on average after losing 9.4% in 2000. But the junk sector remains troubled: If the economy continues to slow, experts say, more high-risk bonds are likely to go into default--meaning the companies that issued them won’t be able to pay interest owed.

Even high-quality bonds aren’t without risk, analysts note. If the economy begins to rebound later this year and market interest rates rise, bonds could produce low or negative returns. That’s the nature of the investment: You’re at the mercy of whatever happens with market rates.

What’s more, investors buying Treasury bonds today are getting the lowest yields in at least two years. That increases your risk if rates suddenly whipsaw.

Still, even in bad years, bonds generally don’t post anywhere near the kind of losses that stocks can suffer.

Example: In 1994, as the Federal Reserve doubled interest rates, the average long-term government bond fund’s total return was a negative 4.6%. Investors’ principal values fell, but they were at least offset by interest earned in the year.

Contrast that loss with the 30%-plus declines in many stock funds over the last year.

What bonds do best, then, is provide a cushion for a stock portfolio, experts note.

Over the last five years, the average long-term government bond fund has produced an annualized return of 7.1%. That still trails the 11.2% return of the average U.S. stock fund in the period--but you should earn more in stocks, because you’re taking more risk.

Investors new to bonds have some basics to learn.

A bond is an IOU from a company or a government entity. The issuer agrees to pay you a set amount of interest each year and to repay the bond’s face value at maturity, which could be many years in the future.

The concept is simple, but many investors struggle to understand bonds--and end up turning to professionals for help.

Understanding yields, “yields to maturity” and the inverse ratio of prices to yields is difficult at first.

What’s more, there are many types of individual bonds, each with a different maturity. Finding prices is more difficult than getting a stock quote. Tens of thousands of municipal bonds are available, many of which trade rarely.

The most important bond concept to grasp is that bond prices and yields move in opposite directions. As bond prices rise, yields go down, and vice versa.

If you buy a new bond paying 6% when it is issued, you’ll get 6% interest each year. But if market interest rates rise a few years later, the bond’s price is likely to decline, because an investor who could buy a new bond with a higher yield wouldn’t pay you full price for your lower-yielding bond.

If you hold your bond to maturity, however, you’ll get back the full face value.

Another key concept: The longer the maturity of a bond, the more volatile its price will be along the way, as it continually reacts to market swings.

Paying for individual bonds is another adventure for investors. Bonds are bought on a bid-asked basis, and the difference, called the spread, is the commission. Under the bid-asked system, a broker will quote two prices for a bond, explains Annette Thau in “The Bond Book” (McGraw-Hill Professional Publishing, 2000). “If you want to buy, you always pay the higher price. If you want to sell, you receive the lower.”

However, Treasury securities can be purchased directly from the federal government at no cost.

If you want to own bonds, is it better to buy an individual bond or a bond mutual fund, if you have the choice? A lot depends on your savvy and how much money you have to invest. The less capital you have, the more sense a bond fund makes--with some caveats.

Many financial planners like to “ladder” bonds--that is, buy a selection of individual bonds that mature every year for, say, 10 years, so that principal is constantly being returned and reinvested.

They prefer that to the relative uncertainty of bond funds. When you buy an individual bond, you get a guaranteed interest rate, a guaranteed maturity date and a guaranteed return of principal (barring the rare default).

You lose those guarantees when you buy a bond fund. Open-end bond funds have no set interest rate and no maturity. Their share values fluctuate with market interest rates, as do their dividend payments.

What you do get in a bond fund is professional management, the possibility of a higher total return than just the interest earned, and liquidity--the ability to sell easily, which is not always the case with individual bonds.

For more information on bonds, investors can try Web sites such as https://www.investinginbonds.com, run by a trade group, the Bond Market Assn. It has generic explanations of what bonds are as well as a glossary. Investors also can get pricing information on some bonds on the site.

The latest edition of “The Bond Book” is a complete look at bonds and bond funds and contains Web site resource information after each chapter.

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Bond Yields: The Long View

Treasury bond yields have dropped sharply over the last decade because of tame inflation and the federal government’s dwindling borrowing needs. The latter factor has cut the supply of Treasury issues relative to demand. But high-risk corporate junk bond yields have surged over the last year amid fears over the slowing economy.

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Yield on KDP Investment Advisors index of 100 junk bonds, monthly closes and latest

Junk bond yield Friday: 11.17%

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Yield on 10-year U.S. Treasury note, monthly closes and latest

10-yr. T-note: Fri.: 4.88%

Source: Bloomberg News