U.S. News

Thinking of Buying Bonds? Use Caution

Laura Bruce, Bankrate.com

Investors and savers looking for alternatives to a risky stock market or low-yielding money market funds have poured into bonds and bond funds. One result has been price appreciation that looks more like the returns seen in equities. But experts say consumers should keep close tabs on improvements in the economy and the eventual rise in interest rates.

"Sooner or later the Federal Reserve will have to start pulling some of the stimulus out. They'll look to raise rates. And when that happens bond prices will start to drop," says Larry Rosenthal, Certified Financial Planner and president of Financial Planning Services in Manassas, Va.

"As the economy repairs itself bond prices will come from deeply discounted back to par. Spreads have started narrowing, meaning that the net asset value (NAV), or the prices of these bonds, have started to rise. Remember, bonds mature at par. People who are trying to buy creditworthy bonds today are buying them at a premium and they're going to mature downward toward par."

Bond prices still rising

Rosenthal isn't necessarily advising against buying bonds, since their prices are still rising, but he recommends that consumers buy bonds for the income first versus the price appreciation. Also, he says, mitigate risk by spreading bond purchases among an array of corporates and municipals in high, medium and low credit ratings. This should give you a blended yield and blended volatility.

William Larkin, fixed income portfolio manager at Cabot Money Management in Salem, Mass., says that for most of his clients he's building bond portfolios with maturities between three and seven years.

"If inflation does surface, and we know that it's going to, I'll be feeding into the rising rates with my maturities. The problem is there's so much slack in the system. I still believe that there's a high risk of deflation, so the short-term trade may be dangerous because you'll be reinvesting in a lower and lower rate," says Larkin.

Less volatility in bond funds

Larkin looks for value and has been able to use individual bonds and bond funds, with their less risk and volatility, to deliver stock-like returns.

"A bond fund example would be Nuveen High-Yield Municipal Bond Fund (NHMAX). I bought this when the crisis occurred. It had fallen 40 percent and was a little overdone. Now, year-to-date it's up over 39 percent. It's still below the long-term trend but it's providing 7.2 percent federally tax-free, which is equivalent to equity returns. It's going to have less volatility but it's going to provide a similar return to the average of the S&P."

Some of Larkin's other holdings are Templeton Global Income Fund (GIM), Oppenheimer International Bond Fund (OIBAX), and PowerShares Emerging Markets Sovereign Debt (PCY). Keep in mind that all of these funds have done very well this year and there's no promise that the trend will continue. As someone who lives and breathes fixed income every day, Larkin knows when to hold 'em and when to fold 'em.

Larkin does recommend that consumers shun Treasuries, as an abrupt shift into more positive economic conditions could send prices plummeting and the impact will be felt quickly. Larkin says you'll have to go out seven to 10 years on the Treasury yield curve to get a decent return and you're simply not being rewarded for taking that risk.