As most readers of this newsletter know, bond prices move in the opposite direction of interest rates. When rates fall, older bonds with their higher payments are worth more than new bonds.

When rates rise, bond prices fall. The reason is simple: Yields on new bonds will be higher than those of older bonds, which won’t sell except at a discount.

For example, who wants to pay $1,000 for last year’s bond paying $60 a year when the same $1,000 will buy a new one paying $75? In that environment, the older bond might sell for $800, leaving the seller with a $200 capital loss.

We have no clue about when interest rates will start to rise. But we are sure they will. Obviously many investors under-stand this, because we’re getting more and more questions from investors wondering what they should do about bonds.

After the bear market of the past two years, many investors realize they need bond funds in their portfolio to reduce risk. But many are skittish. As one reader said in an email: “Given the current low interest rates, how do I purchase bond funds so that rising interest rates won’t have an adverse effect on my bond investments?”

The short answer is you can’t. Bond funds always have interest rate risk. But investors can significantly reduce this risk by investing in short-term bond funds instead of intermediate-term or long-term ones. Sure, short-term bond funds typically have lower yields. But they also have lower volatility – just what today’s bond investors want.

Some investors think they’ll get short-changed by the lower yields of short-term bonds. But from 1973 through 2001, five-year Treasury notes had an annualized compound return of 7.7 percent, higher than the 7.5 percent return from 20-year government bonds. And the Treasury notes had, over that time, about 40 percent less risk than the longer-term bonds.

Still, many investors are waiting to buy bonds, hoping for lower prices. That’s a trap, and the only way out is by following some very clear thinking. Fortunately, Paul Merriman recently provided exactly that sort of clear thinking in one of his weekly columns for CBSMarketwatch.com. I’d like to quote from what he wrote:

“The problems start when investors get confused about why they own bond funds or why they ought to own them. There are three main reasons for owning bonds: The classical reason to own bonds is to receive steady, reliable income. The most common reason to own bonds is to add stability to a portfolio of stock funds. Another obvious reason some people own bonds is so they can buy them at low prices and sell them at higher prices.”

What you should do about bonds depends on what you want from them, as Paul spelled out in his column:

Like many of the rules of good investing, this notion can be challenging emotionally. But of the things that separate successful investors from unsuccessful ones, clear thinking, discipline and long-term thinking are among the most important.

 

 

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