Many investors whipsawed by the stock market have taken note of an enticing alternative: bonds.
Even before the Sept. 11 attacks, the cash flowing into bond funds had reached record levels. And the post-attack uncertainty has stirred even more attention for lower-risk investing.
Experts say the old rules of financial planning still apply: Bonds should be an important component of any portfolio.
But investors should tread carefully, the experts say, especially in the current low interest rate environment. Short-term interest rates are at their lowest in 30 years. If they start to move higher, bond values decline.
"Bond investing is far more complicated than stock investing," said Douglas Gill, chief investment officer at Gill Capital Management Inc., a money management firm. "The smartest guys on Wall Street are on the bond side. They have to know a lot more about the company than just the next quarter's earnings outlook. They have to look out 20 years or more in some cases."
The allure of bonds is simple: When used properly, they give investors safe, predictable returns without the rude machinations of the stock market.
Used improperly, though, bonds can wreak financial havoc every bit as damaging as stocks.
A couple of things are clear.
First is the willingness of many shaken investors to trade the risk attached to stock investing for the lower risk, and lower reward, of bonds.
Bond mutual funds took in a record $16.6 billion in August, shattering the old mark of $12.8 billion set in December 1987, after the Black Monday collapse.
Second, experts say, is how valuable bonds can be in smoothing out the investment ride for even the most aggressive stock buyer.
Those overweighted in the stock market during the past year have suffered heavy losses notwithstanding the market's recent uptick. The average U.S. stock mutual fund is still down almost 19 percent.
Conversely, the average investment grade corporate bond fund gained just over 8 percent during that period, according to Lipper Inc., which tracks mutual fund performance.
"Investors who stuck to a discipline (of diversification into bonds) were spared a lot of pain," said Don Cassidy, a Lipper senior research analyst.
Remember the basics
Bonds are issued mostly by corporations and governments to borrow money at a fixed interest rate.
They are issued in various maturities, such as three years, five years, 10 years and even 30 years, and they vary in how much interest they pay depending on the issuers' credit worthiness and their maturities.
The four major categories are:
U.S. Treasury bonds issued and backed by the federal government;
Municipal bonds issued and backed by cities and other local taxing authorities;
Investment-grade corporate bonds issued and backed by companies;
High-yield (junk) bonds also issued and backed by companies.
All of the above can be purchased at most any brokerage firm, and there are hundreds of mutual funds that specialize in bonds. Additionally, U.S. Treasury bonds can be purchased at Federal Reserve banks.
So what's the proper bond allocation for the average investor? It varies from about 10 percent to 40 percent of a portfolio depending on several factors, said Mario DeRose, a bond strategist at Edward Jones & Co. in St. Louis.
One of the common rules of thumb is the "Rule of 110." Subtract your age from 110, and the resulting number is the percentage of assets investors should have in stocks with the remainder in fixed income.
But age is not the only determinant, or even the most important one, he said. For example, even some young investors may not have the stomach for the wild ride of the stock market and prefer a higher weighting in bonds.
Further, those in the highest tax brackets might want a greater weighting in stocks than bonds, because stock returns are taxed at the capital gains rate of 20 percent, while interest received from most bonds the one exception being municipal bonds is taxed as ordinary income at almost double that rate. Interest on municipal bonds usually is not taxed.
And investors with soon-to-be college-age children should consider short-term bonds because they can be converted to cash more quickly without penalty.
Advice during decline
In the current interest rate environment, Gill recommends bond maturities of less than three years for his clients.
"With shorter maturities, we effectively are insulating our clients on the ride back up with interest rates," Gill said. "As the shorter-term bonds mature, they get to reinvest at the next higher interest rate."
Investors who buy U.S. Treasuries should diversify their holdings across their time of maturities. U.S. Treasuries have no default risk. But investors in corporate and municipal bonds should diversify across both maturities and the entities issuing the bonds because there is a risk of default, Gill said.
DeRose said he was not as concerned as some financial experts about the specter of rising interest rates in the coming years and how that might affect bond values. While it's true that short-term rates have declined dramatically this year and may rise in the next year or so, long-term rates have not moved much all year, he said.
"I think some people are overestimating how much interest rates are going to rise on the long end," DeRose said. "Longer term rates have not fallen like short term rates, so they are not going to rise as much. I think when the economy starts to turn around, short term rates will rise the most, and you won't see much activity on the longer term rates."