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Don’t Ditch Those Bonds

Time to rethink conventional investment wisdom?

Keep bond funds for long-term value.

Peter Gridley

CDs and very short-term bond funds are fine for cash you need soon, but for down the road you should stay with intermediate-term funds.

En español | Classic advice bout diversifying investments tells us that we should choose stocks for growth, high-quality bonds for income and banks for cash. So those of us in — ahem — the prime of life usually own some bonds or bond mutual funds.

Quality bonds lie on the safe side of the investment spectrum, which is another reason we own them. But right now, they may not be feeling especially safe.

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An ironclad law of the universe says that when interest rates rise, the market value of bonds goes down. Rates popped this spring and bond funds took quick hits — losses of 0.5 to 1 percent or so for short-term bonds, 2 to 4 percent for intermediate terms, and 7 percent or more for longer terms. (Another ironclad law says that longer-term funds swing more sharply with interest rate changes than short-term bonds do.) With interest rates predicted to climb, bond fund holders are wondering if they should cut and run.

Surprising benefits

I say no, and for a reason that you might not expect: It's actually possible for your bond funds to benefit from rising interest rates, if you're reinvesting dividends, making only modest withdrawals and planning to hold on to the funds for 20 years or more. That's because your fund is buying the higher-rate securities that are available on the market now, which raises your income yield. Over the years, your gains can more than make up for the principal you lost.

For an example of how this works, I turned to actuary and financial planner Joe Tomlinson of Greenville, Maine. He looked at funds invested in Treasury inflation-protected securities (TIPS), whose drop in value especially alarmed conservative investors. The internal value of TIPS is increased twice a year by the inflation rate, so many investors felt safe.

Say that you invested $290,000 last April 1 in Vanguard's TIPS fund to help pay for your retirement over 25 years. You planned on withdrawing $10,000 in the first year, with an increase to cover inflation each year after that. By the end of June, rising rates had pushed up your fund's yield by 0.83 percentage points. Its market value fell 7.4 percent and you took a $21,500 loss.

Plans ruined? Not at all, Tomlinson says. Thanks to the higher yield, you could increase your withdrawal to $10,350 and the money would still be expected to last for 25 years.

Two things have made TIPS more volatile than other funds. First, they contain more longer-term securities. Second, consumer price increases have been running at historic lows. When interest rates rise and inflation doesn't, TIPS tend to underperform.

No need to jump ship

You could blow your retirement income plans, however, if you bail out of your bond funds and, temporarily, hide the money in bank CDs. You're thinking, "I'll go back into bonds when interest rates stabilize." But no one rings a bell when a rate rise is complete. You're giving up a lot of income while you wait. What's more, when you return to bonds, you'll need to capture a higher-than-average rate to make up for the income you let go. That would mean taking higher risks.

CDs and very short-term bond funds are fine for cash you need soon, but for down the road you should stay with intermediate-term funds.

To prevent apparent loss, some investors might switch to individual bonds. That gives you "emotional control," says Christopher Philips, senior investment analyst for Vanguard. You collect your full principal when the bond comes due. But you don't get the increase in income that bond funds pay. To capture part of a rising rate, you might buy a series (or "ladder") of bonds that come due in different years. But bond funds are easier to own.

Finally, remember one more ironclad law: Interest rates are unpredictable. They might rise gradually just with economic growth; or rapidly if inflation takes hold; or decline if the economy gets squashed again. For the fixed-income part of your retirement investments, a prudent allocation would include a TIPS fund plus an intermediate-term fund — say, a bond index fund or a tax-free municipal fund. Stick with high-quality bonds, Philips says. Take your risks and part of your inflation protection in stocks.

Jane Bryant Quinn is a personal finance expert and author of Making the Most of Your Money NOW. She writes regularly for AARP Bulletin.