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Who needs bonds anyway?
There are four reasons to own bonds...currently, only one seems convincing.
December 19, 2005: 4:18 PM EST
By Michael Sivy, MONEY Magazine editor-at-large

NEW YORK (MONEY Magazine) - Conventional financial planning wisdom says that in a time of rising interest rates, you should keep the bond portion of your portfolio in maturities of five years or less.

That's because the longer a bond's term, the more its price will suffer from a climb in rates. Keep your money in a low-cost short-term bond fund from American Century, Fidelity or Vanguard and you won't get whacked too badly.

That's sound enough advice, as far as it goes.

But with yields on short bond funds running less than 4 percent and with little chance for capital gains, I think it's fair to ask whether there's anything to be gained by following the conventional wisdom, particularly if you're investing with a long time frame.

There are, to my thinking, four reasons you might ever want to own bonds. Today only one of those reasons seems truly compelling -- and in that instance you would want to own bonds or a bond fund with longer maturities.

Let me explain by looking at the four rationales for bonds in general and whether they make sense right now.

1. You want to ride a long-term decline in interest rates

Bond prices move in the opposite direction from interest rates. So you should buy when interest rates are high. That way you not only lock in fat yields but also get a chance to sell at a profit if rates later fall.

For maximum returns in times of falling rates, you want bonds with long maturities -- 20 or 30 years.

Such Treasuries earned nearly 11 percent a year between 1980 and 2001, as Federal Reserve chairmen Paul Volcker and then Alan Greenspan drove down inflation from 12 percent to less than 2 percent, and long bond yields fell to 5 percent, after hitting 15 percent.

It's impossible to have a comparable rate decline today. We could see a slight falloff, as Pimco chief investment officer Bill Gross maintains (see "Bill Gross: Why you'll get rich...very slowly").

But at 4.75 percent, yields on long Treasuries are only half a percentage point above their lows for the decade.

2. You hope to play a short-term rate dip

Even without a sustained decline in interest rates, you can earn good returns on bonds for a year or two if you buy right before an economic slump.

Interest rates typically ease when the economy slows. Right now, if the yield on long-term Treasuries dipped by one percentage point, bond prices would rise about 7 percent.

Including today's yield, you'd receive a total return of more than 11 percent.

But it's hard to see a short-term opportunity in bonds. It's true that yields on long-term Treasuries haven't risen over the past 18 months, even though the Fed has hiked short rates by three percentage points.

And normally that's a sign of a weak economy. Yet gross domestic product continues to grow at an aboveaverage rate. And the threat remains that inflation, fueled by high oil prices, will trigger a rise in rates.

3. You want to earn predictable current income

The beauty of bonds is that they pay steady income. But at today's yields, the income you'd get from top-quality bonds that have little risk of default is too skimpy. You can do better elsewhere.

Among your best alternative income choices are preferred shares. The preferreds of major banks such as Bank of America and Wells Fargo currently pay more than 6 percent.

For investors in the top tax brackets, municipal bonds may also be attractive.

Pimco's Gross owns tax-exempt bond funds in his personal account that pay more than 5 percent. You should also look at high-yielding common stocks.

Bank shares often rally strongly after the Fed has completed a round of interest-rate increases. The current round seems likely to end in 2006.

Shares of Sivy 70 stocks Bank of America, J.P. Morgan Chase and Citigroup all pay at least 3.5 percent and trade at less than 12 times estimated earnings.

4. You want to reduce the swings in your portfolio

The best reason to own bonds -- and perhaps the least appreciated -- is the fact that they smooth out fluctuations in the value of your portfolio.

Stock prices normally rise during an economic expansion; bonds do best in a slowdown. Put the two together and they partially cancel each other out, without cutting into your return much over the long haul.

That's why you want to own them when the outlook for economic growth and interest rates is uncertain, as it is today.

Long-term Treasury bonds are the best counterweight to stocks precisely because they are so sensitive to changes in interest rates. You can get exposure to them through top fund companies' longterm government bond funds or through the Vanguard Long-Term Treasury fund (VUSTX).

Bonds may falter in a boom, when investors fear rates will rise. But when your stocks are tanking, they can ease your pain.

More Investing:

Bill Gross: Why you'll grow rich...very slowly

10 Rock Solid stocks

Money 50: Best funds  Top of page

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