My friend Bill showed me his managed investment account the other day.  “While the S&P 500 is up 14 percent for the year, my account is only up 8 percent,” he moaned.

When I looked at his account, I saw the main reason. Like most investment advisers, Bill’s put 50 percent of his funds into bonds, and the other 50 percent into stocks and funds. The bonds had not gone up in value at all, and were producing about a 3 percent yield at best. So only 50 percent of the account was really in the market, and that 50 percent had actually outperformed the market a bit.

So why does anyone invest in bonds if they don’t perform as well as stocks and funds? That’s a debate that has been going on for a number of years. The rationale is that no one should put all their eggs into the market basket. If the market takes a real dive, you won’t lose all your eggs.

In the good old days that was a pretty good idea because bonds were paying a return greater than inflation. Today it is more questionable. During the past few years bonds have been paying very low returns, and while that might be in line with what the government says is the inflation rate, it doesn’t feel that way in the pocketbook. Investing in bonds over the last few years has not been very profitable.

And yet I do it. But I’m very careful about how I do it. Here’s the potential problem. When interest rates are as low as they are now, the only projected future for them would be to go up. But as interest rates go up, the value of bonds goes down. That’s because nobody wants your stinking 2 percent bonds if they can buy bonds just issued that are paying 3 percent. So your old 2 percent bonds become worth about $70 for every $100 dollars you paid for them.

Of course the saving grace for bonds is that unless the issuer goes out of business (another issue to discuss) upon maturity you will get back the amount you put in. If you think of bonds as a holding tank for some of your investment dollars, it’s a pretty good idea. But the trick when interest rates are low is to only buy short-term bonds, say two to three years in duration. Then you know that you will get your money back in a reasonably short period of time, and the value of the bonds will not go down so much because the money is not tied up for very long.

Another consideration is the financial credibility of the issuer. The best issuer, of course, is the U.S. government. But they pay the least return since everyone knows that it is a safe investment — 100 percent guaranteed. If the U.S. government goes out of business, your money is no good anyway, so you might as well have bonds. Even confederate bonds from the Civil War now have historical value.

As you move away from the most secure, you go to corporate bonds, and you can move from really solid companies to less solid, inappropriately called “junk bonds.” In fact, many are not junk, just not as safe as the best AAA companies. The junk bonds can pay much higher interest rates than government bonds or AAA company bonds.

Many investment advisers recommend only U.S. bonds because they don’t think the increased interest rate warrants the risk. I feel just the opposite. I think that if you buy a short-term junk bond fund, or a group of bonds in diverse industries, so that your risk is diversified, the larger dividend is well worth the risk.

Then there are some alternative bond investments, such as municipal bonds, which are generally tax free and pay an even lower interest rate (but since the return is tax free, the net after-tax result is typically about the same) and BND, the stock market exchange-traded fund for bond funds. That’s been moving down steadily in the recent past.

How to select a municipal bond is worth an article by itself.

One last point: the big advantage of bonds is that on maturity you get your money back. Remember, that’s not really true when you buy a bond fund. So, while bond funds are an easy way to diversify, they eliminate that one big element.

 

Update

 

I did it again. I thought that as soon as someone in the Middle East did a no-no and we were faced with hawks calling for another invasion, gold would skyrocket. But it didn’t happen. There was a possibility that the U.S. would bomb Syria, but the gold buyers didn’t seem to care, and they keep selling instead of buying. Isn’t market prediction a wonderful science?

 

For information about Merv Hecht and more details on the strategies and stocks he writes about in this column, visit his website at DoubleYourYield.com.

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