FOOL ON THE HILL
Broken Bonds

We realize you've just experienced a painful breakup with the stock market, but don't go falling in love with bonds just because you're on the rebound. The plain truth is that looking for love in today's bond market could lead to another broken heart.

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By Mathew Emmert (TMF Gambit)
February 18, 2003

Many investors are just plain fed up with the stock market. After seeing the value of the stocks in their portfolios vanish faster than Michael Jackson's nose, some have quit stocks altogether, choosing instead to seek safety in bonds. If this sounds familiar, be careful.

Bond's big boy
The fact that PIMCO's Total Return Bond Fund, managed by famed money manager Bill Gross, is slugging it out with Fidelity's Magellan Fund for the title of "largest mutual fund in the country" tells this story well.

Many investors, even if they aren't completely cashing in their chips on stocks, are moving significant portions of their portfolios into bonds. Perhaps they're making the move based on savvy advertising by the bond funds' marketing machines, or perhaps even on the advice of a financial planner (if it was a financial planner, it may be time to find a better one).

Sadly, if these investors aren't extremely careful, they could be faced with even greater losses to their hard-earned nest eggs. Not because bonds aren't a worthy investment class, mind you -- and certainly not that I suddenly find diversification unattractive. It's merely the timing of this move into bonds that makes me nervous.

The pitch
Some ads suggest bonds are the safe place to be given the meltdown in the equity markets. Others actually imply the bond market sat idle these many years the stock market soared, and that bonds are therefore poised for superior performance. And, of course, there are always the claims that bonds make safer and less volatile investments than stocks.

Because of this marketing by the fund companies and even some financial professionals, it may surprise you to learn that all of these perceptions are largely false (though the last one is arguable, as you can learn in our Bond Center).

The ads have conveniently omitted the fact that bonds have been soaring right along with stocks for more than 20 years now, and, indeed, that the bond bull market has now outlasted that of stocks. Bonds have enjoyed this solid performance due in part to the general economic success that our country has experienced over this time period, but their true success is largely due to 20 years of declining interest rates. The prime rate is down from over 20% in 1980 (ouch) to a paltry 4.25% today.

Bond prices and interest rates have what is generally referred to as an inverse relationship, which is just a fancy way of saying that when interest rates fall, the price of your bond rises. And in case you haven't noticed, interest rates are at 40-year lows, which has allowed for a nice run in bonds to say the least.

Ground Zero
But how much lower can interest rates go? As a rule, few items in the financial arena have proven more difficult to predict than the direction of interest rates, so I'm not about to try. What we can do as prudent investors, however, is be certain our portfolios don't have an especially large exposure to interest-rate risk. With interest rates at these low levels, rushing into bonds because you're hell-bent on fleeing the equity market is not going to help you manage this risk.

Remember that inverse relationship? If interest rates do begin to rise, the price of your bond is going to fall, creating a loss if you sell your bond before it matures. Put another way, your bonds could become bondage.

Now, it's worth noting that I said, "if you sell your bond before it matures." If we assume there is no risk of default by the issuer, selling your bond before maturity is the only way you can actually lose money. If you can hang on until maturity, your return will equal the bond's yield to maturity.

So, at this point, you might be saying to yourself, "Self, after losing 75% of my portfolio in the stock market, this whole 'not losing money thing' doesn't sound half bad." And if you are saying that, you have a point, but there are still plenty of reasons why loading up on bonds as a stock alternative is a bad idea right now.

A fund has your funds
In all likelihood, you don't own an individual bond with a firm maturity date; instead, you own shares in a bond fund that has a manager, and it is that manager, not you, who will be deciding whether to hold or trade your bonds.

The pressure for a fund manager to outperform funds of the same category is intense. Think your fund's manager will be willing to report a 3% or 4% annual return at next year's shareholder meeting? Perhaps, but if your fund's manager actively trades in pursuit of higher returns, you can lose money, and lots of it.

Did you say 40 years?
There is also that little tidbit I mentioned about interest rates being at 40-year lows. Current yields are far from impressive, and this depicts the vanilla factor of bonds that I'm trying to get across. Without falling interest rates to increase your return, the yield-to-maturity becomes your best-case scenario, and with rates at these levels, your bond returns aren't going to help you make up your portfolio losses anytime soon.

The conventional market wisdom is often a day late and a dollar short. Unfortunately, it's always your dollar, and this could be yet another example of the Wise leading investors to buy high and sell low. You'll simply be using a different product this time around.

There may well be an appropriate place for bonds in your portfolio, but don't be chased into bonds because you've developed a fear of stocks. Let the lessons of a painful equity market make you a better stock investor, not one forced into yet another type of investment that you don't fully understand.

Take a close look at current bond yields, decide if you can live with returns that likely won't be receiving a boost from falling interest rates, and think twice before following the herd into bonds.

Mathew Emmert thinks Fool editor Bob Bobala was lying when he said, "Nah, we don't get very much snow here in D.C." He doesn't own shares in any of the funds mentioned in this article. The Motley Fool is investors writing for investors.