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When the financial crisis hit and the stock market took a sharp turn southward in 2008 and early 2009, investors responded by directing billions and billions of dollars into bonds and bond funds. In times of heightened fear, bonds become a safe haven for battle-scarred investors. And while shifting huge chunks of their money into bonds may have helped some investors sleep better at night in the past few years, there are some serious drawbacks to this strategy.
First of all, you've probably missed out on much of the post-crash rebound if a majority of your assets have been sitting in bonds. Now that the bull market is nearly two years old, investors are finally getting back into stocks. And while you may have missed out on the biggest gains in the stock market, bonds are facing their own set of problems. Bonds are likely at the end of a multi-decade bull market, and warnings of a "bond bubble" are being thrown around in the media with increasing frequency.
But investors who desire capital protection and volatility reduction in their portfolio still need bonds. So how can you approach investing in an inflated but necessary sector that may be edging toward bubble territory?
1) Keep any money that you may need in the next five years in cash
This is as especially important step for investors who are in or close to retirement. While bonds should still account for the majority of your assets if you are in your golden years, be sure to set aside any money that you may need in the next few years in cash. This guarantees that a downturn in the bond market won't meaningfully affect your ability to pay your living expenses in the near-term.
2) Shorten up on duration
Interest rates will rise -- it's a question of when, not if. And when rates rise, bond prices fall. That means that bonds, which many perceive as ultra-safe, could very well lose money. Long-term bonds are more sensitive to rising rates, so make sure you know how much long bond exposure you have in your portfolio. If you own bond funds, you can check your fund's duration, or measure of sensitivity to changes in interest rates, through Morningstar. For example, the Vanguard Long-Term Bond Index ETF (NYSE: BLV ) has an average effective duration of 13.3 years, which means that the fund stands a good chance of getting socked once rates rise. On the other hand, the Vanguard Short-Term Bond Index ETF (NYSE: BSV ) has an average duration of just 2.6 years, which means it will adjust much more quickly to rising rates and not lose as much value in a rising-rate environment.
Of course, you don't want to stuff all your fixed-income money into short-term bonds or bond funds because these securities are yielding next to nothing right now. In my opinion, it's probably a smart idea to target more short-to-intermediate-term bond issues. A solid fund that keeps a relatively low-duration profile while still providing decent yields is Dodge & Cox Income (DODIX). Even if higher rates destabilize some less creditworthy companies, high-quality corporate bonds from stable issuers AT&T (NYSE: T ) , Time Warner Cable (NYSE: TWC ) , and Hewlett-Packard (NYSE: HPQ ) make up half the portfolio, while the other half is held in mortgage securities. The fund's duration clocks in at just 3.9 years, but it has a hefty 12-month trailing yield of 4.9% -- not too shabby. On top of that, the fund ranks in the top 8% of all intermediate-term bond funds in the past 15 years. Dodge & Cox Income is an excellent choice for any fixed-income investor in a multitude of market environments.
3) Don't forget about inflation protection
Rising rates aren't the only threat lurking around the corner – inflation is just waiting to be set free. Retirees on a fixed income can really get socked by rising prices, as their income payments buy less and less in an inflationary environment. To protect your purchasing power, make sure inflation-protected securities have a place in your portfolio. If you are already in retirement, it's not unreasonable to dedicate up to one-third of your total fixed income allocation to these inflation-busters. Vanguard Inflation-Protected Securities (VIPSX) or iShares Barclays TIPS Bond ETF (NYSE: TIP ) are good, low-cost options here.
4) Keep a long-term focus
It can seem counterintuitive to continue buying into the bond market when it is likely at a peak, but it's impossible to time the market exactly. Getting entirely out of the bond market now just isn't a logical move for the vast majority of investors. Even if your bond holdings suffer a small loss in the next few years, keep in mind that as rates rise, the increased coupon payment on newer, higher-yielding bonds will eventually offset the loss in value of your existing, lower-rate bonds. As long as you have enough cash on hand to meet your obligations for the next several years, a temporary dip in the value of your bond holdings won't derail your long-term goals. So make sure you don't sell your bonds and stuff that money into cash the first month that bonds post a small loss.
There will no doubt be some tough times ahead for bond investors, but by sticking to your long-term strategy and selecting smart bond investments, you should come through just fine.
With the stock market getting choppier , it's more important than ever to make sure you have the basics of your investment strategy down pat. See if you're on track by following the "13 Steps to Investing Foolishly."