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Bonds aren't always surest bet for every investor's portfolio

Six months after putting $100,000 into a bond mutual fund, a prospective client presented financial advisor Nancy Coutu with a problem: The investment's value had dropped to $90,000.

"This was her life savings," said Coutu, cofounder of Money Managers Financial Group. "People might think they can't lose 10 percent or 20 percent in a bond fund, but they're sadly mistaken."

The problem, advisors say, is that many investors think all bond investments are risk-free. The truth is more complicated. The idea, advisors say, is to understand the benefits that bonds bring to an investment portfolio and the various risks that come with them.

"Everything has risk," Coutu said. "You just have to understand where the risk is, and then determine if you can tolerate it."


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The first step is to evaluate whether bonds should be part of your portfolio at all. For retirees and others who cannot risk heavy short-term losses in equities or otherwise need the income, advisors say that certain bond investments can help a portfolio by reducing volatility and providing both diversification and income.

But, if you are young or don't need to tap your investments for a couple decades, many advisors recommend dedicating a minimal amount, if any, of your portfolio to bond investments.

"If you have a 40-year timeline, you shouldn't be buying bonds in your [retirement account] with interest rates where they are right now," Coutu said.

From a historical standpoint, the interest currently paid on the ultra-safe U.S. Treasurys is low. The Federal Reserve started lowering its target overnight lending rate, which affects treasury yields, in late 2007 from above 5 percent to a historical low of 0.25 in December 2008. And that's where it stayed until December 2015, when the Fed nudged the rate up to 0.50 percent.

Even with a recent jump in yields on the benchmark 10-year Treasurys from 1.8 percent before the presidential election to 2.4 percent in early December, the long-term average is between 5 percent and 6 percent.


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Stocks, on the other hand, have charged ahead since 2009. The Standard & Poor's 500 Index has shown double-digit returns for all but two years (2011 and 2015). For this year through Dec. 2, the S&P is up 7.2 percent.

Of course, by the looks of it, yields on Treasurys will continue creeping up. Not only has the Fed indicated it will continue its slow approach to raising its benchmark interest rate, the November rise in yields came about largely from expectations that President-elect Donald Trump's plans for infrastructure spending and economic stimulus will translate into more U.S. debt issued and inflationary pressure.

But as yields rise, bond prices fall. According to Morningstar data, all but three categories of taxable bond funds had negative returns for the month trailing Dec. 2 as investors left bonds in droves. Municipal bond funds — which come with tax benefits — were hardest-hit, with all categories showing losses for the month.

Coutu says it's important to remember that bond funds can be volatile, just like stock funds.


"Conservative money goes into bond funds, and conservative investors get nervous very quickly," Coutu said. "If you panic when it drops and take your money out of the fund, you've not only lost money, but the bond fund has to liquidate holdings to pay you, and that affects other investors in the fund.

"It has a snowballing effect," she added.

The longer-term returns on bond funds paint a better picture. Five-year returns across all bond categories are in positive territory, ranging from under 1 percent to more than 6 percent in the high-yield-bond category.

Greg Hammer, president of Hammer Financial Group, cautions against getting out of bonds altogether based just on short-term losses. The way he sees it, asset classes tend to show consistency over time, and falling bond prices are part of a cycle.

"Just because we're hitting that part in the cycle doesn't mean you abandon them," Hammer said. "Trying to time getting in and out of bonds is as hard as timing in and out of equities."


"Investors can seek higher-yielding instruments but must be okay with taking on higher risks. Prudent investment management can make sure the portfolio remains balanced while attempting to seek higher yields." -Charlie Harriman, financial advisor with Cloud Financial

If the higher returns in the high-yield bond category mentioned above is alluring, be aware that they are riskier because of a higher chance they'll default.

For example, U.S. Treasurys are considered very safe because the issuer is the U.S. government and investors trust its ability to pay what's due.

On the other hand, high-yield bonds, or junk bonds, pay higher rates — but only because they are riskier. In other words, the issuer — whether a corporation or a municipality — pays a higher interest rate to attract investors willing to take more risk on a bond backed by an entity with a low credit rating.

"Investors can seek higher-yielding instruments but must be okay with taking on higher risks," said Charlie Harriman, a financial advisor with Cloud Financial. "Prudent investment management can make sure the portfolio remains balanced while attempting to seek higher yields."

But if you can't stomach the idea of higher risk in the bond world, going with less-risky bonds can mean lower returns, which introduces another risk: failing to beat, or barely beat, inflation.


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Government bonds "are not an inflation hedge," said Coutu of Money Managers Financial Group. "They're terrible for long-term money."

Inflation ticked up in the 12 months ending Oct. 31 by 1.6 percent. While that's historically low, if your bond investments are only paying you, say, 2.4 percent, you're barely ahead.

Exactly how much of your portfolio should be in bonds versus equities depends on a bigger-picture look at your financial picture, your risk tolerance — how well you can stomach swings in the value of your investments — and your risk horizon, or how long until you need the money. And that evaluation is independent of current market conditions.

"Bonds are still an effective part of a portfolio," said Hammer of Hammer Financial Group. "They still fill the same roles they always have, no matter where interest rates are."

— By Sarah O'Brien, special to CNBC.com