INVEST IN BONDS NOW-at Your Own Peril

By in Asset Allocation, Bond, Investing, Money Management

MAIN TOPIC: Learn Bond Characteristics and Prosper

When I began investing many years ago, I was quite afraid of investing in stocks because I thought they were too risky.  I believed bonds could get me a bit more return than cash with less risk than stock investments. In general, that belief is sound; but not now.

In “Stop Gobbling Up Bonds,” by Paul J. Lim, January/February Money Magazine, a couple of reasons why investors are seeking bonds now were cited:

  • Fearful investors seek safety in Treasury bonds.
  • Risk seeking investors are chasing higher bond yields.

 Unless these investors hold the bonds until maturity and don’t care about watching their values decline, they will lose money when interest rates rise!

My earliest teacher of investment principles was my dad. He drilled this FUNDAMENTAL BOND PREMISE into me. It served me well in the beginning and still governs my investing today.

The price of a bond moves in the opposite direction of interest rates.

Simply put, investors witnessed this principle during the past decade, to their collective benefit. The Federal funds discount rate (a proxy for most interest rates) went from 6% in May, 2000 to .75% in January, 2011. This drop in interest rates is the predominant REASON BOND VALUES HAVE INCREASED during the past decade. If you held bonds during the past decades, your returns have been stellar!

PRACTICAL APPLICATION: Where do Bonds Fit in Your Portfolio?

Many investors (myself included) are bemoaning the lack of conservative investments available with higher yields. As anyone schooled in investing basics understands, a balanced asset allocation with percentages in stocks, bonds, and cash is sensible.

Then what’s an investor to do with the bond portion of her portfolio NOW?

Since the bond portion is supposed to offer stability and temper volatility, now is a poor time to allocate new monies to bond investments. The value of monies invested now, wil surely decline as interest rates rise. Here are some options for the “fixed” portion of your assets:

  1. If you are holding individual bonds, and expect to keep them until maturity, do nothing. The ups and downs in value are irrelevant as you receive the full (face) value of the bond at maturity.
  2. If  you typically invest in bond funds, only allocate new money to funds with extremely short maturities, or not at all.
  3.  Consider paring down your current holdings in bond funds, to capture the capital gains and shield your money from future losses.
  4. Put new money into a Certificate of Deposit (CD) instead. PFstock had an interesting idea; he recommended finding a 5 year CD with a competitive interest rate. Make sure the “early withdrawal penalty” is not more than a few months interest. That way, you’ll get a decent yield, your principle is protected, and if you withdraw the funds early, you still come out ahead of investing in a shorter term CD with a far lower interest rate. 

In investing as in life, change is a constant. As the markets cycle and interest rates move upward, you’ll have an opportunity to devote resources to bonds offering much higher yields.

ACTION STEPS:

 Get a notebook and label it: “(your name) Personal Finance” and keep it by the computer. Use it to keep all of your personal finance goals, thoughts, activities, and plans.

  • Devote one hour to review your investments.
  • Make sure you understand the investments in your retirement account.
  • Commit to saving money on a regular basis.

If you like what you’re reading, pick up my RSS feed and follow me on twitter so you get the word immediately.  

How are you handling the fixed portion of your portfolio now?

This article is for information purposes only and not as a recommendation to buy or sell any individual securities. The information contained herein may not be applicable for your situation. Consult your ownpersonal advisor for investment information.

image credit: businesspictures