Why should anyone buy bonds?
Today, bonds look like losers. If the economy continues to improve, as currently projected, long-term interest rates will gradually go up. When unemployment comes down, the Federal Reserve will stop repressing short-term rates and they’ll rise, too.
When interest rates rise, the market price of bonds and bond mutual funds goes down. So why would anybody buy or hold bond right now?
Well … I’m holding bond mutual funds, for seven good reasons.
1. I’m not a kid. I don’t want to put all of my savings into stocks. In bad markets, stocks can fall by 50 percent or more. Bonds don’t do that.
2. Over the long term, bond mutual funds benefit from rising rates. As new money comes into the fund, the managers invest it in the new, higher-rate securities. I reinvest all the interest I earn. So even though the market value of my funds declines, the interest earned by my account goes up. That reduces my short-term loss. Over a long period, such as retirement, investors make money from rising rates, even if they’re making regular withdrawals from their fund. Here’s a link to an excellent paper on that subject. http://bit.ly/15v9KVw
3. I keep the duration of my bond funds on the short side. Short-term funds fall less in value when interest rates go up and benefit faster from the higher-rate securities that the managers can now buy.
4. Historically, the returns from short-term bonds and bond funds equal the inflation rate. Right now, the Fed is artifically holding short rates down, but eventually they will return to normal. Over the long run, these bonds should preserve my purchasing power.
5. As a diversification, I hold some money in intermediate-term funds. If the economy stalls and rates fall, I’ll pick up more gains from intermediate funds than from short-term funds.
6. What’s my alternative? I could hunker down in bank CDs while waiting for rates to rise. But in the meantime, I’d be giving up income. High-yield bonds carry more risk and, in the long run, do no better that high-quality bonds — the difference being that the high-yields are much more volatile. Brokers are offering new types of investments, such as floating-rate prime bank funds but they don’t have a track record during a crisis. Blame me for being conservative but I mistrust “magic” new products that supposedly solve the problem of rising rates.
7. I own bonds to protect myself against the high volatility of stocks and the possibility of another epic market drop.
Bottom line: Don’t panic when interest rates go up and the headlines blare. If you’re of an age when bonds make sense, hold onto your short-term and intermediate-term funds. You get the best results from funds with the lowest fees, which would be those from the Vanguard group. Even when you’re making regular withdrawals, income from the fund’s new, higher-rate securities will eventually make up for the market loss. To borrow a term from music, bonds are the “ground bass” of your portfolio — chugging along, providing foundational support.