Stop gobbling up bonds -- they're risky!

bonds.top.gif Paul J. Lim, assistant managing editor


(MONEY Magazine) -- Normally, investors gorge on bonds only when they're scared out of their wits -- typically because they've taken such a beating in stocks that they can't bear the thought of losing one more cent.

Eventually that terror subsides, only to be replaced by greed. That's when investors spurn fixed-income investments and start devouring stocks. When another market cycle ends, they get nervous again -- and the fear-greed seesaw repeats itself.

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At least, that's the way it usually works.

After a decade in which equities have lost ground while bonds have soared 9% a year, we're seeing an anomaly: Fear and greed are working in concert to send money pouring into bonds.

A mind-boggling two-thirds of a trillion dollars has flowed into bond mutual funds since the start of 2009 -- more money than all stock funds attracted during the Internet boom of 1998 to 2000.

"Risk aversion is pushing money into Treasuries," explains Kathleen Gaffney, co-manager of the Loomis Sayles Bond Fund. "But other bond investors are actively seeking risk because they're chasing yields."

And still others are looking to bonds to provide the one thing that stocks haven't been capable of producing since the tech bubble burst in 2000: solid and consistent returns.

Indeed, if you look at where all the money flooding fixed income has been heading, you'll see it's fairly evenly split among funds that hold government-oriented bonds, corporate bonds, and high-risk securities such as junk and foreign debt. All these categories are currently frothier than they've been in years.

Okay, so what are you supposed to do? You know that bonds are an essential part of a conservative portfolio: They provide income and ballast that you just can't get from stocks.

If you're retired and relying on investment income to pay the bills, it's not as if you can safely go with equities only. And the Federal Reserve's strategy of keeping short-term rates near zero has made it impossible to earn much of anything on your cash.

Yet you can't ignore the risks in today's bond market. Many experts believe that we're in the middle of an inflating bond bubble that's soon to pop. Even if that doesn't happen, the strategies that made you money in 2009 and 2010 are unlikely to work very well this year.

Your task, then, is to find smarter ways to allocate your bond portfolio, whether you view bonds as a safe haven, are aiming for the maximum return, or simply need decent income.

This story will take you through each of those three scenarios, making specific suggestions for funds and individual issues. The good news is that there's no need to get too fancy: In all three cases, you can build your portfolio strategy around one core total bond market fund.

Scenario 1: You're terrified the financial crisis isn't over yet ...

What you've been doing: Buying treasuries. Ever since the global financial panic struck, investors have been piling into Treasury bonds for a simple reason: There's virtually zero risk that the U.S. government will default. Yet Treasury bonds aren't nearly as secure as you may think.

MONEY said the same thing last year at this time, warning that a bubble forming in Treasuries was ready to burst. The reason: The economy was expected to start recovering, pushing interest rates higher. (When rates rise, bond prices fall, and vice versa.)

But in February, when the Greek debt crisis erupted, the exact opposite happened. Fears that the global economy could be headed for a rare double-dip recession sent investors around the world racing into Uncle Sam's warm embrace. Interest rates sank.

And by August the average long-term government bond fund had gained more than 20% in total returns (the combination of bond yields plus changes in the underlying prices of those securities).

Then, in the next four months -- when confidence in the economy improved and rates began to climb -- long-term government bonds plunged 10%. So much for the idea of Treasuries as stable.

"I don't think investors fully appreciate the equity-like volatility we've seen in this market," says Joseph Davis, chief economist at Vanguard.

This year most experts say they believe that rates will rise because they see clear signs that the economy is finally getting up off the floor. Gross domestic product is expected to grow 3.3% worldwide this year and 3.7% in 2012, according to IHS Global Insight.

While some economists do consider deflation a significant threat (see the box on page 124), that's a minority view. It now appears that central banks around the world are willing to do whatever it takes to prevent the global economy from sinking into Japanese-style deflation (see "Where to Invest Now," page 74).

In November the Federal Reserve announced that it would buy hundreds of billions of dollars of Treasuries to keep rates stable. In the weeks after that, investors actually sold off long-term Treasuries, apparently because they're convinced that Fed chairman Ben Bernanke will succeed in reinflating the economy.

Concludes Carl Kaufman, head of fixed-income strategy at Osterweis Capital Management: "Loading up on Treasuries now is sort of like buying Internet stocks in early 1999. The game at this point is, 'Let's see if there's still time to sell to the greater fool before the music stops.' "

Smarter strategy: Shift to shorter maturities and diversify your treasury holdings.

If you're set on hanging on to your government bonds because of the credit safety they provide, at least move to shorter-maturity ones with lower durations, advises Steven Huber, a fixed-income fund manager for T. Rowe Price.

Duration is a technical term that measures how sensitive an investment is to interest rate fluctuations. A typical total bond market fund has a duration of nearly five years.

That means that if rates were to climb just one percentage point, the fund would probably drop 5% in price. And a one-point increase in rates is about what economists at Standard & Poor's are forecasting by the spring of next year.

Shoot for an average duration of less than four years for your total fixed-income portfolio. Yes, that portfolio would stand to lose 4% of its value with a one-point rate rise. But because the broad bond market is paying out nearly 4% in income, once you factor in those yields, you'll come close to breaking even.

An easy way to bring down your duration is to add a short-term government bond fund to the mix. The average such fund has a duration of about 2.1 years, but Sit U.S. Government Securities (SNGVX) boasts a duration of just 1.1 years. Yet the fund still yields 2.9% -- a full percentage point higher than its average peer -- and has beaten 99% of its competition over the past five, 10, and 15 years.

Meanwhile, protect yourself against inflation risk with individual Treasury Inflation-Protected Securities, a.k.a. TIPS, whose principal increases when the consumer price index does. Buy them commission-free at treasurydirect.gov.

What if things get so bad that deflation strikes? TIPS still don't look like a bum deal, as long as you hold them to maturity. At that point you'll recoup your original investment, no matter how much prices may have fallen in the interim.

Finally, put a small portion of your fixed-income portfolio -- say, 10% into government-backed mortgage-related bonds, which should do fine if rates rise gradually. A simple way to do that is through a fund like Vanguard GNMA (VFIIX), which has a duration of 1.9 years and invests more than 80¢ of every dollar in Ginnie Mae mortgage securities.

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