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Should You Still Own Bonds?

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One reason asset allocation strategies are so popular among investors is that they intuitively make sense. Most people think of the stock market as being the riskier place to put their money, but that they'll receive potentially greater rewards from investing in stocks. Conversely, the popular view of the bond market is that it's the place for conservative investors to park money they can't afford to lose, with bond buyers willingly sacrificing growth potential in exchange for the relative stability and steady income that bonds typically promise.

But recently, all the conventional wisdom about stocks, bonds, and asset allocation has gotten turned on its head. Even as the stock market has risen to all-time record highs, bonds have suffered big price declines that have awakened many bond-fund investors to the reality that their bond investments can actually lose money. With the specter of further rate increases in the future as the Federal Reserve contemplates an exit from its quantitative-easing bond purchases, one question arises: Do asset allocation strategies that advocate owning bonds still make sense?

The extent of the bond-market damage
Losses throughout the bond market in recent months have been substantial, and how much of that investors have suffered depends on exactly where they had their money. On the passive-index side, all-purpose bond ETF Vanguard Total Bond (NYSEMKT: BND  ) has declined by almost 4% since the end of April, even after you take into account the income that the ETF has paid. Actively managed bond ETF investors haven't fared better, with the popular PIMCO Total Return ETF (NYSEMKT: BOND  ) having lost 4.5% over the same time frame.

But long-term bond investors have seen truly massive declines. The iShares Barclays 20+ Year Treasury ETF (NYSEMKT: TLT  ) is off almost 14% since the beginning of May, as long-term rate movements have produced much larger capital losses in long-duration bonds. The sharp move has given bearish bond investors huge profit opportunities, as the leveraged inverse bond ETF ProShares UltraShort 20+ Year Treasury ETF (NYSEMKT: TBT  ) has posted gains of more than 30% over the same period.

Even some bonds that many thought would be immune to interest rate movements have seen losses. iShares Barclays TIPS Bond (NYSEMKT: TIP  ) , which buys inflation-adjusted bonds, has dropped almost 8% over the past few months. The reason has been that inflation isn't driving rates higher, but rather the expectation of tighter monetary policy and better economic conditions.

What bonds do
So far, strong returns from stocks have generally offset bond declines in balanced portfolios. But what's happened over the past few months should alert you to the potential for further capital losses from your bond holdings if the rising-rate trend continues, and further rate increases could come even if the stock market falters from its record-setting move.

But that doesn't mean eliminating fixed-income investments like bonds from your portfolio entirely. Instead, you can make some moves within the fixed-income arena to reduce your potential risk of loss while still giving you the benefits that bonds give you.

One thing to consider is to focus on shorter-term bonds. The interest rates they pay aren't as high, but they tend to produce smaller losses for a given increase in rates. In addition, using individual bonds rather than bond mutual funds and ETFs can help you avoid permanent losses, because if you hold the bonds to maturity, you'll receive the full principal amount back regardless of bond-market swings along the way.

An even better alternative for many is to use CDs rather than traditional bonds. In many cases, CDs pay better rates than high-quality bonds even though CDs are guaranteed by the federal government. If rates rise, your CD won't lose value, and you can even take money out early if you're willing to pay what is often a modest penalty. Similarly, savings bonds tied to the rate of inflation don't offer huge returns right now, but they do give you full principal protection and hold their purchasing power through automatic inflation adjustments over time.

Be smart about bonds
Discovering that bonds can lose value has been a painful experience for many investors, but they still belong in most people's investment portfolios. For money you need within the next few years, finding the right investment vehicle to avoid the volatility of the stock market is more important than ever. By being smart about which fixed-income investment to make, you can find the right balance between risk and return for your financial situation.

All that said, having too much money in bonds is also a big mistake. Millions of Americans have completely missed out on the huge gains in the stock market since 2009, putting their financial futures in jeopardy. In our brand-new special report "Your Essential Guide to Start Investing Today," The Motley Fool's personal finance experts show you why investing in stocks is so important and what you need to do to get started. Click here to get your copy today -- it's absolutely free.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.


Read/Post Comments (28) | Recommend This Article (50)

Comments from our Foolish Readers

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  • Report this Comment On August 14, 2013, at 11:37 AM, inreality01 wrote:

    And the answer is..........

    No!

    Of course, diversify your investments but convert bond assets into real estate, gold, silver and other commodities that have tangibility to them.

    Keep some money in savings, in stocks, mutual funds and annuities as well if you can.

    Now, if we could dramatically cut government, government spending, regulation and taxes then we could all be much more prosperous!

    God Bless America.

  • Report this Comment On August 14, 2013, at 11:42 AM, EnigmaDude wrote:

    Long term investors like myself see this as a buying opportunity for bonds. Short term price declines just mean that I can add more and lower my cost basis.

  • Report this Comment On August 14, 2013, at 12:30 PM, rhealth wrote:

    Should You Still Own Bonds? Nope.

  • Report this Comment On August 14, 2013, at 5:30 PM, korax777 wrote:

    Go individual bonds. Diversify type of bonds (corporate, govt, etc.) Go short term duration. Balance with CDs and some cash.

  • Report this Comment On August 14, 2013, at 6:00 PM, physicsisphun wrote:

    korax777 is right on, and the folks saying a flat 'no' are off base. My "fixed income" account that is invested in individual corporation bonds has been doing just great. Corporations are responding to the interest rate trend by taking the opportunity to issue new bonds at todays rates, calling old issues, and giving folks holding the latter great returns. That's happened to three of my holdings bnow, all with nice gains. Stay short term, and you won't get hurt by rates.

  • Report this Comment On August 14, 2013, at 6:04 PM, dgmennie wrote:

    I want an investment that pays me a reasonably predictable 5 to 7 percent every month. Sure the stock marlet is up and doing great (for the moment) but what am I suppose to do? Cash out my bonds, pay fat comissions to do so, then put whatever is left into dividend-paying stocks? At the next bump in the equity road these stocks could well cut off their dividend payments altogether. Then what? I still need to eat, buy gas, and pay taxes.

    Short -term bonds are not the answer either, unless you have millions to invest and it doesn't matter if your income is trashed by a few tens of thousands of dollars annually while you wait for longer-term bonds to look less risky. Try this for awhile and you will soon be getting breadcrumbs to add to your Social Security income. If you live in a tent on the beach in a warm climate you might get by on Social Security alone for awhile.

    It is time to recognize that the US Govenment's QE policies and artificially-low interest rates have robbed income investors blind. The solution is NOT taking on risky equity investments and hoping for the best. Survivors of the 2008-2009 market crunch can give you the insight on this strategy. Its not pretty, and there are no advisory newsletters around that can help most small investors survive during such a meltdown.

    Face it fools. You have all been hosed! When enough people realize this, only then might some real changes be made that provide a reasonable return on conservatively-invested money. I'm looking for a dependable income stream to live on, not a "lotto" chance to score big on some techie startup that promises to be the next Apple. Everyone peddling investment advice uses this whiz-bang scenario and is is WRONG 99% of the time.

  • Report this Comment On August 14, 2013, at 6:16 PM, SkepikI wrote:

    ^ Amen. And if you look closely at bond yeilds and price activity, you realize fairly quickly that the price increases can't continue but more importantly, the rates are so low you can't possibly make up for the price declines anymore.

    THIS MEANS YOU ARE NOT BEING COMPENSATED FOR THE RISK YOU ARE TAKING!

    And yes I am shouting. Dan you missed this obvious piece of advice. When the risk reward ratio is rigged against you as it is in QE, its time to FLEE.

    If the past few months of portents of things to come have not put you on alert, I don't know what can. Take a GOOD hard look at the permanent impairment of Capital you will suffer if rates go up by 1 or 2%. Then look at your income remaining...can you stand this? I couldn't, so I am out. yes out completely from bonds, and I might go back in if there is a further 5-10% decline in price. Yes I suffer some lack of return (not as much as you might think, calculate it out) but neither do I risk a 10% decline in my capital, which I cannot stand, nor recoup..its too late in the game for me.

    Make your own assessment, but be skeptical and be pragmatic.

  • Report this Comment On August 14, 2013, at 6:23 PM, hspindel wrote:

    The answer from here:

    Buy investment grade corporate bonds as part of your portfolio and hold them until maturity. Assuming you buy bonds that don't default (stick with quality companies), you know your guaranteed rate of return in advance.

    In today's lousy interest rate return market, buy only short-term corporates. I'm out to 3 years maximum. When long-term yields pick up again, my bond money will be rolled over into investment grade longer-term, better yield corporates.

  • Report this Comment On August 14, 2013, at 6:24 PM, LeeG3 wrote:

    My problem with bonds boils down to one thing: Ratings! Do you remember when GM bonds were highly rated? Or when state and local governments were considered the safest? We now know that the ratings can't be trusted for the long term because moves by the FED or bad decisions by the issuers can drive the ratings (and by definition, the prices) down quickly.

    Ratings drive the price you pay which is why "junk" bonds are cheap, i.e. pays more interest for a smaller buy-in. The AAA-rated bond would pay little interest for the cost to buy the bond. But that AAA-rating can drop quickly if the company has a bad year and Moody's decides that it is only BBB-rated now. Obviously, if you hold the bond until it matures, you get the full value except when the company goes bankrupt (GM!)

    Stock prices are driven by the market which is "efficient"*. But bonds are driven by both the market and the rating agencies/FED. The retail investor has no idea when the rating services or the FED decides to change their minds. In my mind, that makes stocks a better choice over bonds.

    * Yes, I am assuming that there is no insider knowledge.

  • Report this Comment On August 14, 2013, at 7:08 PM, Seanickson wrote:

    bonds can certainly be risky but I'd feel a lot better bout owning the 10 year treasury at 2.7% then I would have at 1.7%

  • Report this Comment On August 14, 2013, at 7:19 PM, SkepikI wrote:

    ^ until you realize that even your 2.7% for a whole year can be wiped out by a very small rate move when the price of the bond plummets 3%. Just a small calculation exercise can help you determine just how likely that might be.

    I plan to wait till we get a little closer to 5% and even that might not be enough to pay me for the risk....

  • Report this Comment On August 14, 2013, at 8:02 PM, doodke wrote:

    I do not see the value of this article - the purpose of investing in "actual" bonds is to get predictable cash distribution. Heck, if I did that between 2000 and 2008 I would be a lot richer than investing in funds and stocks.

    My philosophy is to:

    1) Create a bond ladder going all the way to my statistically anticipated death (even if I die earlier the bonds will continue generating cash for my beneficiaries),

    2) Go for high yield corporate bonds (6+ %) with generally respected companies. I do not believe in the halo of "Investment Grade" as all the ratings are based on the past and have absolutely nothing to do with the future.

    3) Buy non-callable or "make whole " callable bonds only

    $) Collect the cash and sleep well....

  • Report this Comment On August 14, 2013, at 8:08 PM, dggerman wrote:

    The question is:"Should You Still Own Bonds?" not should you be trading bonds and not should you buy or continue to hold a bond mutual fund.

    If I have a bond, which I bought a long time ago, and it's paying a "good" return, why should I sell it? Shouldn't I continue to hold it? i.e. continue to own the bond?

  • Report this Comment On August 14, 2013, at 9:53 PM, hasimoto wrote:

    Could you have said the same about owning stocks in January of 2009? I bet, you were second guessing on your recommendations. It is not one asset class over the other. My feeling, diversify over multiple asset classes to reduce volatility. Short duration bonds are OK in the bond portion of asset allocation.

  • Report this Comment On August 14, 2013, at 10:13 PM, marei wrote:

    Bonds give you the emotional stability to successfully invest in stocks for the long haul.--Tom Reilly

  • Report this Comment On August 14, 2013, at 10:50 PM, mikecart1 wrote:

    To label all 'bonds' as bad is like labeling all stocks as 'good' because their return on average is 'better than a savings account interest rate'. There are lots of bonds that are worth owning as PART of your overall investment portfolio. Some of the best bonds pay a dividend/distribution monthly and annual yields overall are well over 5%.

    So, no, I'm not going to get rid of all bonds and I'm not going to sell all stocks.

  • Report this Comment On August 15, 2013, at 12:37 AM, Cruiser55N wrote:

    Central banks have blown the mother of all bond bubbles, and this isn't going to be the first bubble in financial history that ends happily. Most everyone will hold the oceans of fixed rate paper all the way down, there can't be any net selling, but you aren't required to be one of them.

  • Report this Comment On August 15, 2013, at 12:53 AM, Cruiser55N wrote:

    BTW, a quick reality check. The general stock market has not reached all time highs in real terms. The S&P 500 would have to increase another 25% to reach its inflation adjusted high of the year 2000. So after 13 years long term holders of stocks are generally still down, and down by a lot. Furthermore when the index finally reaches a new high in inflation adjusted terms you will still have a tax liability to overcome due to the nominal increase. In past secular declines recovery in real terms has taken almost a quarter of a century; so that nominal gain and your tax liability could be large.

    The bond market is probably on the verge of similar performance likely having peaked during the last 12 months or so.

    Keep it real or pay the price.

  • Report this Comment On August 15, 2013, at 7:09 AM, smacunalum wrote:

    Upon retirement plan on having enough investable assets to be able to live on those assets returning 5% into perpetuity plus having some reserve for stocks. Yes that means laddering bonds in retirement.

  • Report this Comment On August 15, 2013, at 10:55 AM, enginear wrote:

    Bonds are not very well understood by many stock market investors. It takes a strange set of math and of looking at rates and time value, and yes ratings.

    The fact is that bonds rise and fall and funds are constantly trading. Individuals generally buy for income, and often let the bonds mature. If the debacle we keep hearing about with rising inflation due to the rise in government debt ever comes to pass, load up. Right now, I think rates will work against the price of the bond for a while.

    Should you own them? Depends on what you're trying to do.

  • Report this Comment On August 15, 2013, at 1:57 PM, SkepikI wrote:

    <Should you own them? Depends on what you're trying to do> A wise man.

    Now from a "wise guy" - if you are trying to PRESERVE CAPITAL, particularly if you are near enough to your minimum nut, AND you want to draw 3 or 4% a year from your nut, just barely making the income you need... owning a lot of bonds now is a big risk. Owning a lot of bonds once they fall 10% or so and are paying much better interest rates is much less risky.

    Still young? Overabundent in capital? Either way you can recover from a Bond price disaster. Depends on what you are trying to do indeed.

  • Report this Comment On August 16, 2013, at 3:05 PM, pamrw wrote:

    Interesting that neither the article nor any of the comments have mentioned holding the individual bonds until maturity, and not caring about the price swings between now and then.

  • Report this Comment On August 16, 2013, at 3:26 PM, Rover3321 wrote:

    As Pamrw notes holding individual bonds, particularly tax free munis and the like that are yielding 4-5% to maturity is a good way to incorporate a safe and steady srteam of income inside a diversified portfolio

  • Report this Comment On August 16, 2013, at 3:42 PM, PaFrogboss wrote:

    Actually, both the article and some of the comments DO mention "holding the individual bonds until maturity", but as usual the emphasis is on bond FUNDS, which are an entirely different matter from investing in BONDS.

    All bond funds are, to some extent, constantly trading and therefore constantly subject to the effects of interest rates and market psychology. As hspinel wrote -- "Buy investment grade corporate bonds... and hold them until maturity. Assuming you buy bonds that don't default (stick with quality companies), you know your guaranteed rate of return in advance.

    I have one bond position in my ladder which has currently "lost" almost 20%. (I got greedy, and went into the "junk" market.) But if I was right about the company -- and I still think a bankruptcy is highly unlikely -- I will get back full face value at maturity, and in the meantime I'm getting 8%+ on face.

  • Report this Comment On August 20, 2013, at 2:57 PM, YoungMoneyJB wrote:

    As several people here have already pointed out, holding individuals bonds to maturity ensures you will receive par value back. Implying that people should not own individual bonds because they temporarily lose value is alarmist at best. If you plan to hold to maturity, the monthly prices swings are 100% irrelevant. This is no environment to be swapping out old bonds either, as anything new you buy will be at an inferior rate.

    Bond funds and ETFs rob you of the ability to simply hold on until maturity, as there is no fixed date to get par value back. These are not good to own during rising interest rates. Buying individual short term paper and holding to maturity is a fine defense, there is no need to overcomplicate fixed income.

  • Report this Comment On August 22, 2013, at 12:02 PM, SkepikI wrote:

    ^ <Bond funds and ETFs rob you of the ability to simply hold on until maturity, as there is no fixed date to get par value back. These are not good to own during rising interest rates. Buying individual short term paper and holding to maturity is a fine defense, there is no need to overcomplicate fixed income.>

    Yes, BUT... individual bonds then expose you to the risk of complete loss, just ask any bondholder of GM, Detroit, Stockton, Enron, and a host of others. If you have a substantial sum in retirement, you will need to pay close attention, unlike in a Bond Fund. I am not arguing for bond funds, just reminding the tempted that you can pick your poison, but you cannot change the game.

    I strongly believe and you can prove to yourself with some simple math that owning bonds now, until interest rates rationalize is a prescription for you being shorted on payment for risk. IN FACT just the past week ought to convince you- many of the classes of Bond Funds just dropped so far they wiped out a whole years worth of interest, some TWO whole years. This can happen again in the artificial environment QE has created.

    And, if you think you can "dodge" risk in this area by owning individual bonds, while professional traders experience it in large portfolios, be my guest. Small numbers of bonds, maybe. If you are a REALLY good bond picker and pay close attention AND are lucky? Maybe. I will stand clear....

  • Report this Comment On September 29, 2013, at 2:32 AM, realitytest wrote:

    I'm definitely a noob, but if I question a wisdom pointed out by so many experienced investors here (and it also includes advisers consulted recently about how to invest what stands to be 1/2 my total nest-egg - an inheritance of $400K just received. Driving me nuts, because of today's economy and my age - 67).

    This business of allegedly being protected by holding bonds to maturity...

    As I consider my own options, inflation looms large in my thinking especially having lived in Israel while inflation stood at 700%. It's better than nothing, sure, but if the bond's real value has been massively eroded by inflation while maturing - and I don't even mean such a horror scene as the one I mentioned - well, what good is it, really? I don't count that as "return of principle".

    Am I missing something about this "safety factor" so many have highlighted about buy and hold bond investing?

  • Report this Comment On October 12, 2013, at 5:59 AM, thidmark wrote:

    Anyone dumb enough to invest in GM, Detroit or Stockton deserves to be parted from their cash. Two of the worst cities in America and a company that gave us the Aztek.

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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