NEW YORK (CNN/Money) -
I would like to adjust my asset allocation by adding bonds or bond funds to my portfolio. But with interest rates at such low levels, isn't this a bad time to do so?
-- Donald E. Robbins, Abiliene, Texas
I know exactly how you feel.
You look around and see that 10-year Treasury bonds have recently been at their lowest levels since the early 1960s, and you figure, they can't possibly go any lower. Once the economic recovery takes hold, they've got to go up from here. It's inevitable.
So buying bonds at this point would be foolish because once interest rates rise, the value of bonds will fall as a result of that see-saw relationship between bond prices and interest rates. Thus, buying bonds now would be the equivalent of buying stocks back in early 2000 when they were at their peaks.
Don't try to time the market
The problem with this kind of reasoning, though, is that it suggests we really know the limits of how low Treasury yields can go. Or that we know that the economy is about to recover soon and that interest rates must rise when that happens.
Yes, I agree all these things seem likely. With 10-year Treasurys recently yielding less than 4 percent, I think it makes more sense to expect them to rise than fall -- or at least to believe there's more room for them to head north than farther south. And I would be surprised if Treasury yields didn't increase from here within the next year or so, and certainly within the next few years.
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But it's also important to remember that a year ago, when 10-year Treasuries were yielding closer to 5 percent, people were saying much the same thing -- that the economy would recover and drive interest rates higher. Now here we are a year later and rates have fallen by roughly a percentage point.
My take on all of this is that predicting movements in interest rates is extremely difficult and ultimately a waste of time (and often money). Which is why I don't believe people should jump in and out of the bond market any more than they should jump in and out of the stock market. I mean if your timing skills were so great, you would have bought bonds back in early 2000 before stocks tanked, right?
Diversify and hedge your bets
I believe virtually all investors should always hold some of their money in bonds or bond funds. But that percentage should be based not on their outlook for bonds, but on their investment horizon and risk tolerance. The longer you'll be investing your money, the smaller your stake in bonds. The more apprehensive you feel about your portfolio's value yo-yoing up and down with the stock market, the more you should put in bonds.
But once you decide on the right mix of stocks and bonds for you, I think you ought to pretty much leave it alone. (For help figuring out your right mix, try our Asset Allocator.)
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I also think investors should hedge against the risk of rising interest rates in the bond portion of their portfolios. And the way I believe they should do that is by sticking to bonds with short-to-intermediate-term maturities or bond funds that hold such bonds. Generally, that translates to bonds with maturities of two to eight years or so. Over long periods of time, bonds in this maturity range give you a good portion of the return that long-term bonds offer without subjecting you to the same risk of price fluctuation.
(To get the names of some bond funds that hold bonds in the short-to-intermediate range, I suggest you check out our Fund Screener.)
One final note: In choosing a bond fund, you want to pay special attention to the fund's risk profile. Our screener will provide links that can help you evaluate risk. And while you're at it, limit yourself to funds with below-average annual operating costs. With yields as low as they are today the last thing you need are lofty expenses further reducing your take.
Walter Updegrave is the author of "Investing for the Financially Challenged" and can be seen regularly Monday mornings at 8:40 am on CNNfn.
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