Is it time to buy bonds?

It’s a trick question. If you’re a steady, long-term investor who puts money into the financial markets every month or quarter, as most of us should, it’s always time to buy bonds. A well-balanced portfolio should contain some bonds or bond funds as a hedge against the greater risks of stocks.

Right now, bonds might seem an appealing option with the volatility of the stock market. But before you divert all your money to bonds and bond funds, consider a few points.

First, beware of chasing yesterday’s great deal and getting in too late. Much of the recent bond gain is a result of falling interest rates. While interest rates could continue downward, they are at rock-bottom levels already. During the next few years, therefore, it’s more likely rates will go up than down.

The critical point one often missed by investors who aren’t familiar with bonds is that when rates rise, bond prices fall. If you spent $1,000 today for a new 10-year Treasury paying, say, 4.3 percent, no one would give you $1,000 for it next year if newer bonds were paying 6 percent. Your bond’s price would fall until its fixed annual payment of $43 equaled 6 percent of the price giving its new owner the same yield he’d get on a new bond.

Your $1,000 bond would have to fall to about $700, since $43 is about 6 percent of $700. If you were forced to sell, you’d suffer a $300 loss of principal. And if you didn’t sell, you’d be stuck with a low yield.

In real life, other factors influence these figures. But this “interest-rate risk” is a major factor in determining bond returns, which are the combined value of interest payments and price changes. Obviously, a big price drop could overwhelm the small gain from interest payments.

Similarly, if interest rates fall, bond prices rise because investors will pay more to get the generous older bonds. With price increases included, many bond funds have returned 6, 7 or 8 percent since the start of the year, even though the interest rates paid by the bonds they hold are much lower.

Long-term bonds unnecessary

To neutralize interest-rate risk, you can buy bonds with the intention of holding them until they mature. Pay $1,000 for a five-year bond and you’ll get interest payments for five years, then get your $1,000 back at the end of that time, even if the bond’s price fluctuates in the meantime.

Don’t expect to need all your money at once? Then buy a series of bonds with different maturities, a technique called laddering.

Bonds with longer maturities tend to have higher yields, since investors demand compensation for the risks associated with tying their money up longer. The longer a bond has to maturity, the more violently its price will swing as interest rates change. For example, if you had a bond maturing tomorrow, guaranteeing you’d get your $1,000 back in 24 hours, you wouldn’t care what happens to interest rates between now and then. But if you had a 30-year bond, you’d care a lot.

Is it worth taking the extra risks to get the higher yield paid by bonds with very long terms?

Generally, it’s not, most experts say.

From 1980 through 2001, the five-year Treasury note returned an average of 9.1 percent a year, when both price changes and yield were combined, according to a study by fund company Neuberger Berman. During the same period, the 30-year Treasury bond returned 9.6 percent a year.

At the same time, standard deviation, a measure of the risk from price changes, was 6.2 percent for the five-year note and a much more hazardous 12 percent for the 30-year bond.

“In other words, the five-year note produced 95 percent of the return of the 30-year bond, with only 52 percent of the risk,” Neuberger Berman concluded.

In fact, using performance data from 1960 through 2001, the company found that portfolios using five-year Treasuries outperformed portfolios using one- or 30-year Treasuries regardless of whether the stock/bond mix was 50/50, 60/40 or 70/30.

There’s little reason, then, to take on long-term bonds. In fact, the company says, investors can do quite well with bonds maturing in as little as two years.

Portfolio should include bonds

How much of one’s holdings should be in bonds?

For most people, at least 20 percent. That doesn’t take enough away from the stock portfolio to stunt overall returns if stocks and bonds produce average long-term gains. But it can significantly reduce the risk of suffering a long-term loss in your portfolio as a whole. (This assumes, of course, that the markets return to the patterns of the second half of the 20th century.)

Neuberger Berman found that a portfolio of 90 percent stocks, 0 percent bonds and 10 percent cash returned an average of about 12 percent a year in any five-year period selected between 1951 and 2001. But the return was nearly as high, about 11 percent, when the mix was 70 percent stocks, 20 percent bonds and 10 percent cash, while a 50/40/10 percent mix returned about 10 percent.

Bottom line: I wouldn’t pour everything into bonds just now because the risk of rising rates undercutting prices is too high.

But if I had no bonds, I’d begin gradually building bond holdings until they comprised at least 20 percent of my portfolio perhaps 40 percent or 50 percent, or more, if I were in or near retirement. I’d hire a financial planner to help set the target.

I’d probably use bond funds rather than individual bonds. The constant monitoring, buying and selling required would make it too difficult to use individual bonds. With a fund, the managers do the work to maintain an average maturity that fits the investor’s goals.