The pros and cons of bonds

When I discuss investments with people in Scotts Valley who are not my clients (yet), they often say, “Most of my money is in bonds.”
Upon further discussion, they reveal that what they own are bond mutual funds. Then I go into my long and, I hope, not-too-boring spiel about why bonds are not the same as bond mutual funds.
What I consider bonds are fixed-income securities — IOUs from corporations or governments — that pay a set amount of interest on set dates and then pay back the principal on a maturity date. Bond mutual funds have none of these qualities.
As interest rates on bonds have mostly gone down since 1981, it’s hard to remember what it was like when rates went up. But if you bought the longest-term U.S. Treasury bond in 1977 when it sold as a new issue for $1,000, by 1981 you would have watched your bond plummet in value by nearly half. That’s because interest rates on long-term Treasuries soared from 7.75 to 15.6 percent over those four years. Because you owned an individual bond rather than a bond mutual fund, you had the assurance that if you waited 26 years till the bond matured in 2007, you would get your full $1,000 back. And you would have collected $77.50 in interest every year.
Bond mutual funds offer no such assurances. If you put $1,000 into a bond mutual fund and then watch interest rates go way up, the value of your shares will go down — and probably stay down. Eventually, the interest the bond fund pays may rise, but probably not enough to offset the drop in the value of your shares.
I bring this up because of numbers released recently by Lipper Research showing that between March 2009 and March 2010, investors pulled $18.4 billion from stock mutual funds and poured $416.8 billion into bond funds. It seems the stock market collapse in early 2009 scared a lot of people out of stocks, and they moved into bond funds for safety. The stampede has pushed up prices for bonds, and that has pushed down interest rates.
But if interest rates rise, the prices of bonds and bond funds will drop. And there are signs that interest rates will rise in the months and years ahead. The U.S. Treasury will sell more than $2 trillion of T-bonds and T-bills this year to help fund its deficit. More bonds coming to market tends to push rates higher. The brokerage firm Morgan Stanley recently forecast that the yield on the 10-year Treasury will rise from its current level, under 4 percent, to 5.5 percent by year-end.
Meanwhile, it appears the U.S. economy is getting stronger. If that’s true, it will lead to companies borrowing to grow their businesses and individuals borrowing to buy homes and cars. That demand for credit is likely to push up interest rates.
If it’s not true, and the economy weakens, that will lead to larger federal deficits and more need for the government to borrow. Either way, it looks to me that interest rates are headed higher.
I don’t want to give the impression that I’m totally against bond funds. They’re better than individual bonds in some cases. I think bond mutual funds are a good way to invest in junk bonds or bonds issued in foreign currencies. But those investments are aggressive bets on the future of certain companies or countries.
Investors looking for safety are better off with top-quality, individual bonds. The people who have flocked into bond mutual funds may discover that the safety they thought they were getting is just an illusion.
Mark Rosenberg is an investment consultant for Financial West Group in Scotts Valley, a member of FINRA and SIPC. He can be reached at 439-9910 or mr********@fw*.com.