Bond investors today fall into one of three categories: smart, scared or oblivious.

Let’s take the last group first. Whenever you hear someone say they plunked money into a long-term bond fund because it returned 12% annually for the last 30 years, all you can do is sigh.

The old boilerplate is true: Past returns are no guarantee of future results. But in this case, past returns are impossible to replicate. Thirty years ago, long-term bonds yielded over 12%. Today they yield about 3.7%.

[ad#Google Adsense 336×280-IA]There is no way anyone investing in long bonds today is going to earn the equity-like returns of the past.

And long bonds fall the most when interest rates rise.

(You’ll hear the howls eventually.)

The Fearful

Much more common is the fixed-income investor who is scared and currently owns no bonds because he feels that it’s just a matter of time before interest rates go up.

He may well be right. But he’s wrong to ignore bonds entirely.

For one thing, if you own high-quality individual bonds you will get all your principal and interest back if you hang on long enough. (Something no bond mutual fund can promise.) You have to weigh a temporary decline in your bonds’ market price against earning essentially nothing in cash. Short- to medium-term bonds are a better bet than a zero-yielding money market.

What the Wise Know

But rather than being oblivious or scared, why not be smart? Smart fixed-income investors understand something important that 95% of bond buyers don’t. They know their bonds’ duration.

Picture bonds as a seesaw. If interest rates go up, bond prices go down. If interest rates go down, bond prices go up.

That’s because a lower-yielding bond has to drop in price to make it attractive enough to compete with new bonds at higher yields. (Otherwise it would be illiquid.) Likewise, bonds will rally in price as interest rates drop to bring their prices in line with new offerings.

These fluctuations are just a fact of life and shouldn’t scare anyone out of the fixed-income market. If you know your bond’s duration.

Duration is a measure of this interest rate risk. It’s not enough to know that your bond will drop if interest rates rise. You need to know by how much. For instance, a bond with a one-year duration would lose only 1% of its value if rates were to rise 1%. A bond with a duration of 10 years would lose 10% if rates were to rise by the same amount.

Risk-averse investors or those with a short-term time horizon should only consider bond funds with a short duration.

Others may look at ones with longer durations. Yet even aggressive income investors shouldn’t climb too far out on this limb today.

The Fed is tapering its $85-billion-a-month bond buying program. (It is now merely a $65-billion-a-month bond buying program.) But when the Fed is keeping interest rates artificially low, it’s the same thing as pushing bond prices artificially high. When the adjustment comes, it could be painful.

But it could be even more painful to sit for months or years in a cash account that guarantees you a negative return after inflation.

So don’t avoid bonds. Just understand the risks. And know your bond fund’s duration.

Because smart beats scared or oblivious every time.

Good investing,

Alex

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Source: Investment U