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Based on standard asset allocation models, I figure my portfolio should consist of 60 percent stocks and 40 percent bonds. But with impending interest rate increases, won't bonds only go down in price? So why should I own bonds at all?
-- Ray Stone, Rome, New York
I totally understand your skepticism about owning bonds. In fact, I remember that many investors were also reluctant to own bonds back in the late 1990s, though the reason then was, Why own bonds when stocks were clearly generating much superior returns?
In both cases, I don't think the logic is completely sound.
Reasons for bonds
For one thing, we don't really know what the future holds. Yes, given all the signals the economy is throwing off these days -- strong job growth, upticks in inflation -- I do believe that rates are likely to go up from here. But I'm not positive that there will be a big jump in rates, so I'm not going to make an all-or-nothing bet and completely forsake all bonds.
Besides, even if you and I are right, it's not totally clear what the effect would be. I would expect bonds to get hurt, but rising rates aren't exactly a tonic for stocks either. So should we avoid stocks too?
If we start making our investing decisions on the basis of one factor, we end up with a portfolio tailored to do well only if a relatively narrow scenario unfolds. That's great if we've got the scenario right -- not so good if things unfold differently.
Factoring in the possibilities
So how do we factor in the possibility of rising rates? Well, my advice is to continue to diversify by holding both stocks and bonds, but to make yourself less vulnerable to rising rates with the bonds (or more likely, bond funds) you hold.
We know, for example, that longer maturity bonds get hit more by rising rates than shorter maturity bonds. And we also know that, over long periods of time, short- to intermediate-term bonds offer a good portion of the returns of long bonds with much less risk.
To me, that argues for keeping your bond portfolio toward the short-to-intermediate end of the maturity spectrum, say, two to five years.
Similarly, we know that, all other things being equal, bonds with higher coupon rates tend to do a bit better than bonds with lower coupon rates in periods of rising rates. That means that, generally, corporate bonds, both high-quality and high-yield (aka, junk) will hold up a bit better than Treasury bonds when rates rise.
This isn't always the case. Sometimes, for example, the spread between high-yield bonds and Treasuries can shrink as rates rise, causing high-yield bonds to underperform.
Still, I think that owning a wide variety of bonds makes sense. That variety should include Treasuries, government agency, high-quality corporate, high-yield and, depending on one's tax bracket, municipals.
Given the potential for higher inflation, I'd also throw in TIPS (Treasury Inflation-Protected Securities), though I wouldn't pig out on them because demand has been so high that their prices have been bid up and their inflation-protected yields bid down.
You should also keep in mind that even though the price of your bond or bond funds will get hit when rates rise, interest payments get reinvested at higher rates. Similarly, to the extent your portfolio has short-term bonds that repay principal, you'll also be able to re-invest your principal at higher rates, a process that mitigates the price-zapping effect of rising rates.
Of course, it's much easier to take advantage of this process if you own a bond fund rather than a portfolio of individual bonds. Most funds own hundreds of bonds, which means the fund is always collecting and then re-investing interest and principal payments. And bond funds also offer individual investors the option of re-investing their interest payments and any other distributions into new shares of the fund.
Diversify your exposure
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If you're really, really concerned about taking even a small hit to principal in the bond portion of your portfolio, you can even move some of your bond allocation into ultrashort bond funds (under two years) and money-market funds.
One final note: before you start shifting your bond money around, I suggest you bone up a bit on the different types of risks in bonds and learn more about how to gauge a bond's (or bond fund's) vulnerability to rising rates.
You can do that by checking out our Money 101lesson on bonds and by checking out a column I wrote recently that discusses duration, the most accurate indicator of how rising or falling rates are likely to affect a given bond or bond fund.
Armed with that knowledge, you can begin building yourself a bond portfolio that, while hardly immune to rising rates, at least won't get slaughtered by them.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Mondays.
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