Hooked on Bonds? 4 Cautionary Tactics for 2012

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[dropcap]W[/dropcap]e’re three years past the bear-market bottom and investors are showing no signs of warming up to stocks. From 2009 through 2011 a net $175 billion was yanked from stock mutual funds, while bond funds took in a net $742 billion. The bulk of the flight from stocks happened in the last half of 2011. Investors spooked by our debt ceiling debacle and Europe’s dysfunction over its sovereign debt problems pulled $141 billion from stock funds while adding a net $55 billion to their bond funds.

And 2012 is starting out the same. Through the first six weeks of the year another $7 billion was pulled out of stock mutual funds while bond funds saw their coffers grow by nearly $40 billion. Our growing bond addiction is easy to understand. For the past 12 months a benchmark bond index has posted double the return of the S&P 500 without the volatility drama.

Understandable, but still quite dangerous. If you’re nursing a growing bond addiction you could be setting yourself up for some major hurt.

Check the forecast

Blame this on bond math. Yields are now so low that there’s little room for them to keep sliding. That means there’s less possibility of getting capital appreciation on top of the income portion of your bond return. Remember, when yields fall, prices rise, creating capital appreciation. That’s why 2011 turned out so well for bond investors: Yields went from low to extremely low, giving a nice total return pop. But now with yields starting extremely low, you can’t bank on more capital appreciation.

Factor in inflation

If you’re investing for a long-term goal — retirement, perchance? — what you really need to pay attention to is your net real return after factoring in inflation. If you’re hiding out in Treasuries, chances are you’re not keeping pace with inflation. The 10-year T note yields 1.9 percent right now, while core CPI is running 3 percent. You’d have to stretch all the way to a 30-year Treasury to break even with inflation, but that’s taking on a ton of interest-rate risk. Speaking of which …

Recognize why history isn’t on your side

Right now the Federal Reserve has stated its intention to keep rates low through late 2014. That would create a benign environment for bonds. But this is the lull before the storm. We’re at the end of a long, profitable bond bull market that has been playing out since the early 1980s, when the yield on the 10-year Treasury note peaked above 15 percent. As the T-note has taken a long ride down to today’s sub 2-percent level, that created juicy total returns. But again, from today’s low start point, the long-term trend is that rates must rise. Not necessarily to 15 percent (let’s hope not!) but nor is 2 percent normal. As yields rise prices fall. It’s the same bond math in reverse. That will put pressure on any capital appreciation and can even create capital loss.

Give stocks their proper due

That’s not to suggest that bonds are bad. Anything but. Treasuries and high-quality corporate bonds are the ballast that anchors your portfolio in stormy times. But if you’ve spent the past few years shifting a sizable chunk of your investment portfolios out of stocks and into bonds, you’re setting yourself up for either disappointment (returns matching current yields with low or no capital appreciation, leaving you short of inflation) or hurt (watch out when rates rise.) The smart move is to revisit your friendly online allocation tool, or dial up your advisor, and make sure your portfolio is giving stocks their proper due.


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Carla Fried

Carla Fried is a freelance journalist who has covered just about every nook and cranny of personal finance for media including Money Magazine, The New York Times, and CBS MoneyWatch.com. Prior to launching her own reporting and writing business in 2002 she was a senior writer at Money and the managing editor of Quicken.com.

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