But we hope the air comes out slo-ow-ly, so the debt bubble can deflate slowly, too.
We’ve already had a tiny taste of higher rates, with no ill effect. Mortgages are up 0.57 percentage points from their March lows. One-year Treasuries are paying 48 percent more. Given time, investors can adjust.
Still, bondholders face a disagreeable choice. Whenever interest rates rise, bond prices fall. In April, the cruelest month, corporate-bond mutual funds dropped 2.5 percent. Faced with the certainty of a loss, should investors sell, or what?
Before doing anything, ask yourself why you bought bonds in the first place. For diversification? That need still exists. For income? You now may get bigger checks. For safety? Bonds will do the job. Stock prices swing widely; bond prices, only modestly. If you need cash, your bond investments will be on tap even if stocks have dropped.
Looking only at investment returns, how you divide your money between stocks and bonds may not matter much. Bonds performed better than stocks in eight out of the past 20 years. (I’ll bet that surprises you.)
I asked Ibbotson Associates to compare the performance of 11 different portfolio allocations over the past 20 years. A portfolio 100 percent invested in stocks averaged 12.99 percent. A portfolio 60 percent in stocks and 40 percent in government bonds did 12.66 percent–almost exactly the same, and with much less risk!
In earlier 20-year periods, majority-stock portfolios outperformed those with a majority of bonds–a more “normal” result, which may well recur during the next 20 years. Who knows? But these findings suggest that you needn’t agonize over the theoretically “right” percentage of your hoard to keep in bonds. Bonds are for whatever money you must keep safe.
There are two types of bond investors:
^ Safety investors: When you want to keep money pretty safe, look to short- or intermediate-term (three- to seven-year) bonds and bond funds. Or buy Treasuries free and hold them to maturity (see treasurydirect.gov). Short terms give you liquidity (or go to cash); medium terms give you better rates.
For taxable money, look to tax-free municipals. “Anyone in the 28 percent bracket and up does better with munis than Treasuries,” says Theresa Havell of Havell Capital Management in New York City.
Investors are panting for TIPS (Treasury Inflation-Protected Securities). Part of their return depends on the bond market and loses value when interest rates rise, but part is adjusted for inflation twice a year. TIPS belong in tax-deferred accounts. The inflation adjustment you get semiannually is taxed, even though you don’t get the cash until the bond matures or is sold.
No one cared about TIPS when inflation was sliding down–even though you could buy them at prices so low that they paid a higher yield than straight Treasuries did. During last month’s inflation scare, TIPS got popular and their prices jumped. Then they fell again. But when you’re investing for 10, 20, 30 years, these price points are no more than a “tiny blip in the larger scheme of things,” says John Brynjolffson, chief TIPS cheerleader at the bond-management firm Pimco. At current prices, you’d want TIPS if you thought that inflation would average more than 1.75 percent over the next 10 years. Fund families with TIPS funds include Vanguard, T. Rowe Price and Pimco.
^ Income investors: Mary Miller, head of T. Rowe Price’s fixed-income division, likes corporate-bond funds (hers yields 5.22 percent), compared with Treasury funds (3.7 percent). She’s also high on high-yield-bond funds, especially the “conservative” ones that own a lot of bonds rated BB (just below investment grade).
Two other possibilities are Ginnie Mae funds, invested in mortgage securities, and international-bond funds. Internationals rise when the dollar declines; over the past 12 months they’ve gained 16 percent. Andrew Clark, senior research analyst at Lipper, suggests putting one third of your bond money into corporates, one third overseas and one third into Ginnie Maes.
For a more daring option, check out Treasury strips, says Irwin Kellner, chief economist for the North Fork Bank on New York’s Long Island. Brokerage firms strip the interest payments off Treasury securities and sell them to you separately. You receive all the income, and somebody else has to worry about the principal.
Do remember that the interest your fund pays will eventually cover any loss of principal. For example, assume that rates rise 2 percentage points over the next two years. The interest on a five-year bond would cover the loss in just 17 months.
Obviously, there are no miracles here. Bond investors will lose some principal. Still, bonds do the job they’re designed for, so there’s no reason to bail. If growth slows and rates don’t rise, you’ll be full of smiles.
