After strong bond run, experts warn not to sell whole stake

NEW YORK -- Bond funds enjoyed a surprisingly strong run this summer, but analysts say their advance had more to do with fear than fundamentals, as weaker-than-expected economic data and terror concerns made investors uneasy about equities.

Earlier this year, as the Federal Reserve began raising the federal funds rate off a 45-year low, many on Wall Street were predicting steep declines in the price of bonds, which fall as their yields rise.

However, despite the steady upward march of short-term rates, domestic fixed income funds are up so far this quarter. According to fund tracker Lipper Inc., they've risen an average of 2.77 percent since the end of June. U.S. Treasury and high-yield funds posted above-average returns, while mortgage funds were at the lower end of the spectrum.

Better than half those gains came in August, when anxiety about oil prices and potential attacks on the Olympics and the political conventions was at its peak, prompting a flight to safety among investors. Now that some of those fears have subsided, or been factored into trading, bond prices are likely to resume their decline.

"The reason bonds have done well this quarter ... the actual technical term is 'risk aversion,'" said Andrew Clark, a senior research analyst with Lipper. "When people are feeling fairly conservative and risk aversion is high, that's often good news for bonds."

But from a financial planning perspective, it would be a mistake to sell all of your bond funds. While it's easy to get sidetracked by returns, wise investors know that the point of holding bonds isn't so much to profit as it is to balance risk.

"A few months ago, everybody 'knew' rates were going up and the bond market was going to do terribly, and that didn't happen," said Michael W. Boone, a financial planner in Bellevue, Wash. "That's usually the way markets work. When everyone is betting one way, things don't go that way."

Whenever something shocks the market, Boone said, U.S. government bills, notes and bonds invariably rise in value, as investors rush for the highest level of security they can find. After Sept. 11, 2001, investors all over the world bought Treasuries because of the perceived safety of U.S. government paper -- even though the terrorist attacks occurred on U.S. soil.

Bonds, especially Treasuries, "can be a life preserver for portfolios when people are on the verge of drowning," Boone said.

For most investors, it makes sense to keep at least 10 to 20 percent of your investment portfolio in fixed-income securities, no matter what's happening in the market. But that doesn't mean you should set it and forget it: There are ways to position your holdings to your best advantage.

For example, in a rising rate environment, investment professionals say it makes sense to favor fixed-income investments with shorter maturities. Longer bonds -- those with maturities of up to 29 years -- are appealing because they usually pay higher yields, but their value can drop steeply when rates are rising. Those with shorter maturities pay lower yields, but tend to be less volatile.

The Fed has indicated it will tighten rates at a "measured" pace. Most analysts interpret this to mean hikes of 25 basis points at every meeting, which would put the federal funds rate at 2 percent by the end of the year, and bring at least a 1.25-percentage-point rise next year. But fiscal policy is driven by a number of factors, from job market growth to inflation -- so how far and how fast rates will rise remains a matter of some debate on Wall Street.

If you think rates will rise slowly, then your best investment is probably a diversified bond holding with an intermediate maturity, which would include exposure to Treasuries, mortgages and corporate bonds. If you fear the Fed will act more swiftly, and you are a fairly sophisticated investor, then it makes sense to go entirely short or to invest in a reverse bond fund, which is designed to perform in inverse correlation with the market.

If you're a more passive investor -- one who rebalances their portfolio annually -- you could get well-rounded exposure to the domestic bond market through an index fund. This is probably the least risky bond investment, especially now, when the market is in transition.

"Trends in the bond and stock market have been running weeks rather than months this year," said Clark, of Lipper. "So unless you're good at catching that, and you're good at reshuffling your portfolio fairly frequently, the best thing is to diversify."

On the Net:

www.lipperweb.com