After seeing your stock portfolio decimated by the bear market, you might longingly wish you had kept more of your money in bonds. And after Wall Street's recent rally, you might think that now's a good time to get out of stocks. If you're thinking about making that switch, make sure you first understand exactly what you're getting into.
Bond turbulence
As rocky as stock investors' ride has been over the past 18 months, the bond markets have arguably had an even harder time:
- Although the stock market has remained open and functional throughout the crisis, bond markets have seen some serious market failures. Holders of toxic assets such as mortgage-backed securities have had difficulty finding buyers. And investors who bought auction-rate securities as short-term savings vehicles got a rude awakening last year, when they weren't immediately able to get their cash back.
- In the corporate world, many firms previously considered ultra-safe have suffered credit downgrades. General Electric
(NYSE:GE) and even Berkshire Hathaway(NYSE:BRK-A) (NYSE:BRK-B) are among companies that previously had AAA ratings before being knocked off the top pedestal. - Although municipal bonds have performed fairly well so far in 2009, long-term munis still trade at yields higher than comparable Treasuries -- even though interest on munis is federally tax-free. Those high yields are good for investors, but they also indicate continuing uncertainty about the financial condition of states and municipalities.
Meanwhile, Treasury yields remain at extremely low levels -- even though they have produced negative total returns for investors so far in 2009. What's an income investor to do?
Two signs of trouble
There are two main problems with investing in bonds right now. First, because yields are generally fairly low, you don't get a lot of protection against potential future inflation. Second, in order to get higher yields, you either have to take on greater risk of default by buying corporate bonds, or extend your time horizon to buy bonds with longer maturities, which expose you to more interest rate risk.
To see how such risk has already hurt Treasury bond investors, just look at prices for the 30-year long bond just since mid-February:
|
Date |
Yield |
Price |
|---|---|---|
|
Feb. 17, 2009 |
3.49% |
100.17 |
|
April 28, 2009 |
3.95% |
92.06 |
Source: The Wall Street Journal.
As you can see, a less than a half-percentage-point rise in the yield cost investors an 8% loss in the value of their bonds. And while anyone who holds the bond to maturity will eventually earn their full principal back, they may have to put up with below-market interest payments until 2039.
Bonds turned upside down
Another troubling trend comes from this week's announcement by General Motors
But that hasn't stopped bonds from getting interest from all corners. Activist Carl Icahn is reportedly taking a big stake on bonds of MGM Mirage
Your best course of action
All this should convince you that bonds aren't always a conservative investment. Analyzing corporate debt, for instance, carries many of the same risks -- and potential rewards -- that stock investing can give you. With companies in trouble, bonds can often bring you a higher-return opportunity than shares. And even bonds with no default risk whatsoever can create big losses if interest rates turn against you, while inflation can leave bonds worth a lot less.
Bonds deserve a place in most investors' portfolios. But relying on them exclusively could be riskier than you think.
More on investing for income:
- 5 traps you should avoid now.
- Will these 3 stocks see their dividends burn out?
- This stock is screaming, "Buy me!"
