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Income Investing

Dump Your Bonds? No Way

This is shaping up as the worst year for the fixed-income markets in more than a decade. Still, bonds belong in most portfolios.

Some bond-fund managers are telling me that they are more enthusiastic about stocks than about the stuff they get paid to invest in. Their reasons vary, but generally it comes down to this: The economy is improving, and that should translate into higher stock prices. But a stronger economy is also causing an uptick in interest rates, and because bond prices and rates move in the opposite direction, this is shaping up as a lousy year for most segments of the fixed-income market.

See Also: Why a Savvy Bond Manager Is Buying Stocks

So far this year, Treasuries, municipals, investment-grade corporates and mortgage securities have all registered negative total returns. That's likely to still be the score at year-end. Junk bonds continue to show a small gain, but that, too, might fade into a loss by the time we ring in the new year.

Following a three-decade-long bull market in bonds, I can understand that you might be shocked by this year's losses. Although most bonds sank in 2008 (U.S. government debt being the notable exception), the last year the Treasury-heavy Barclays U.S. Aggregate Bond index ended in the red was 1999, and the loss was a mere 0.8%. So it's reasonable to ask, as some of my readers are, if it still makes sense to keep bonds or bond funds if it looks like we might have another year or two of depreciation.

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My advice depends on whether you want income or total return, the length of your time horizon, and your alternatives for the money. But, to end any suspense, I will say this: Quitting bonds altogether is wrong. There are two exceptions. One is if you are so wealthy that you have no problem earning next-to-nothing in a bank account or T-bills. The second is if you are young and just starting to save for retirement. In that case, bonds can wait. Instead, I'd recommend that you build a portfolio with stock funds in the Kiplinger 25 or use a fund that tracks Standard & Poor's 500-stock index.

But if you're reading this, I suspect you aren't a kid. You're probably so bummed by the recent downturn that you're wondering if it's time to shift to CDs, despite their puny yields. Here's why you should be less bummed about bonds and why you should stand pat the rest of this year.The worst appears to be over. Most of the bond market's losses this year occurred from early May through early July. Since then, prices and yields have stabilized, and I see no reason to think the nasty losses will resume.

Reliable income. Prices may have fallen, but nearly all bond funds and individual bonds continue to pay interest. If Detroit's bankruptcy filing leaves you queasy, restrict your muni investments to bonds secured by revenues from essential services or the general obligations of state governments and wealthy suburbs and counties. Sell any others. Or trust that good muni fund managers will be fussy about the safety of their picks.

Knee-jerk selling creates opportunities. This is a moment when a flexible, actively managed fund can be worth its cost. Madcap sellers have created a raft of bargains that are ripe for skilled buyers, many of whom run funds. "In the next year or two, we're going to find ways to make a little bit of money a lot of times," says Rick Rieder, whose BlackRock Strategic Income Opportunities Fund can invest in any part of the bond market. Unfortunately, his fund levies a sales charge. Two no-load, go-anywhere funds in the Kip 25 are Metropolitan West Unconstrained Bond (symbol MWCRX) and Osterweis Strategic Income (OSTIX).

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Don't join the knee-jerk sellers. Every so often, a herd of traders will sell good bonds (and stocks) to protest the words or actions of Congress or the Federal Reserve Board. If you sell during these trading spasms, you'll probably end up as sorry as all those wrongheaded people who bailed out of stocks in June.

Jeff Kosnett is a senior editor at Kiplinger’s Personal Finance.